Working Paper: CEPR ID: DP15422
Authors: Taisuke Nakata; Sebastian Schmidt
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 policymaker who is sufficiently less concerned with government spending stabilization than society eliminates expectations-driven liquidity traps.
Keywords: Effective Lower Bound; Sunspot Equilibria; Monetary Policy; Fiscal Policy; Discretion; Policy Delegation
JEL Codes: E52; E61; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| raising the inflation target (E52) | exacerbate deflationary pressures (E31) |
| appointing an inflation-conservative central banker (E58) | exacerbate deflationary pressures (E31) |
| raising the inflation target in a state of low confidence (E52) | reduced output and inflation (E31) |
| prioritizing inflation stabilization in a state of low confidence (E63) | reduced output and inflation (E31) |
| desired consumption increases but cannot be matched by income (D10) | rise in the real interest rate (E43) |
| rise in the real interest rate (E43) | clear markets (G10) |
| adverse effect on inflation (E31) | negative feedback loop (D87) |
| negative feedback loop (D87) | further depressing demand (D12) |
| appointing a policymaker less concerned with government spending stabilization (E63) | eliminate expectations-driven liquidity traps (E41) |
| increasing government spending in a liquidity trap (E62) | worsen stabilization outcomes (C62) |
| worsen stabilization outcomes (C62) | raising deflationary pressures (E31) |
| policy framework that disincentivizes excessive government spending (H61) | prevent expectations-driven liquidity traps (D84) |