DP7397 Expectations, Deflation Traps and Macroeconomic Policy

Author(s):	George W. Evans, Seppo Honkapohja
Publication Date:	August 2009
Keyword(s):	Adaptive Learning, Fiscal Policy, Monetary Policy, Zero Interest Rate Lower Bound
JEL(s):	E52, E58, E63
Programme Areas:	International Macroeconomics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=7397

We examine global economic dynamics under infinite-horizon learning in a New Keynesian model in which the interest-rate rule is subject to the zero lower bound. As in Evans, Guse and Honkapohja (2008), we find that under normal monetary and fiscal policy the intended steady state is locally but not globally stable. Unstable deflationary paths can arise after large pessimistic shocks to expectations. For large expectation shocks pushing interest rates to the zero lower bound, temporary increases in government spending can be used to insulate the economy from deflation traps.