DP15171 Expectations, Stagnation and Fiscal Policy: a Nonlinear Analysis

Author(s): George W. Evans, Seppo Honkapohja, Kaushik Mitra
Publication Date: August 2020
Keyword(s): Adaptive Learning, Expectations, Fiscal policy, New-Keynesian model, Stagnation Trap
JEL(s): D84, E52, E62, E63, E71
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15171

Stagnation and fiscal policy are examined in a nonlinear stochastic New-Keynesian model with adaptive learning. There are three steady states. The steady state targeted by policy is locally but not globally stable under learning. A severe pessimistic expectations shock can trap the economy in a stagnation regime, underpinned by a low-level steady state, with falling inflation and output. A large fiscal stimulus may be needed to avoid or emerge from stagnation, and the impacts of forward guidance, credit frictions, central bank credibility and policy delay are studied. Our model encompasses a wide range of outcomes arising from pessimistic expectations shocks.