DP7931 Fiscal Policy in an Expectations Driven Liquidity Trap

Author(s): Karel Mertens, Morten O Ravn
Publication Date: July 2010
Keyword(s): confidence shocks, fiscal policy, liquidity trap, sunspots
JEL(s): E30, E50, E62
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7931

We examine the impact of fiscal policy interventions in an environment where the short term nominal interest rate is at the zero bound. In the basic New Keynesian model in which the monetary authority operates a Taylor rule, globally multiple equilibria arise, some of which display all the features of a liquidity trap. A loss in confidence can set the economy on a deflationary path that eventually prevents the monetary authority from adjusting the interest rate and can lead to potentially very large output drops. Contrary to a line of recent papers, we find that demand stimulating policies become less effective in a liquidity trap than in normal circumstances. The key reason is that demand stimulus leads agents to believe that things are even worse than they thought. In contrast, supply side policies, such as cuts in labor income taxes, lead to relative optimism and become more powerful.