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Expectations-Driven Liquidity Traps: Implications for Monetary and Fiscal Policy

  • Taisuke Nakata
  • Sebastian Schmidt
American Economic Journal: Macroeconomics
vol. 14, no. 4, October 2022
(pp. 68-103)
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Abstract

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 policy-maker who is sufficiently less concerned with government spending stabilization than society eliminates expectations-driven liquidity traps.

Citation

Nakata, Taisuke, and Sebastian Schmidt. 2022. "Expectations-Driven Liquidity Traps: Implications for Monetary and Fiscal Policy." American Economic Journal: Macroeconomics, 14 (4): 68-103. DOI: 10.1257/mac.20190228

Additional Materials

JEL Classification

  • E31 Price Level; Inflation; Deflation
  • E52 Monetary Policy
  • E61 Policy Objectives; Policy Designs and Consistency; Policy Coordination
  • E62 Fiscal Policy
  • E63 Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
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