DP15422 Expectations-driven liquidity traps: Implications for monetary and fiscal policy

Author(s): Taisuke Nakata, Sebastian Schmidt
Publication Date: November 2020
Keyword(s): discretion, effective lower bound, Fiscal policy, monetary policy, Policy Delegation, Sunspot equilibria
JEL(s): E52, E61, E62
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15422

We study optimal time-consistent monetary and fiscal policy in a New Keynesian model where occasional declines in agents' confidence give rise to persistent liquidity trap episodes. Insights from widely-studied fundamental-driven liquidity traps are not a useful guide for enhancing welfare in this model. Raising the inflation target, appointing an inflation-conservative central banker, or allowing for the use of government spending as an additional stabilization tool can exacerbate deflationary pressures and demand deficiencies during the liquidity trap episodes. However, appointing a policymaker who is sufficiently less concerned with government spending stabilization than society eliminates expectations-driven liquidity traps.