DP9643 Escaping the Great Recession

Author(s): Francesco Bianchi, Leonardo Melosi
Publication Date: September 2013
Keyword(s): Bayesian methods, Markov-switching models, Monetary and fiscal policy interaction, Policy uncertainty, shock-specific policy rules, zero lower bound
JEL(s): D83, E31, E52, E62, E63
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9643

We show that policy uncertainty about how the rising public debt will be stabilized accounts for the lack of deflation in the US economy at the zero lower bound. We first estimate a Markov-switching VAR to highlight that a zero-lower-bound regime captures most of the comovements during the Great Recession: a deep recession, no deflation, and large fiscal imbalances. We then show that a micro-founded model that features policy uncertainty accounts for these stylized facts. Finally, we highlight that policy uncertainty arises at the zero lower bound because of a trade-off between mitigating the recession and preserving long-run macroeconomic stability