Working Paper: CEPR ID: DP2948
Authors: Jess Benhabib; Stephanie Schmitt-Grohé; Martin Uribe
Abstract: Once the zero-bound on nominal interest rates is taken into account, Taylor-type interest-rate feedback rules give rise to unintended self-fulfilling decelerating inflation paths and aggregate fluctuations driven by arbitrary revisions in expectations. These undesirable equilibria exhibit the essential features of liquidity traps, as monetary policy is ineffective in bringing about the government?s goals regarding the stability of output and prices. This Paper proposes several fiscal and monetary policies that preserve the appealing features of Taylor rules, such as local uniqueness of equilibrium near the inflation target, and at the same time rule out the deflationary expectations that can lead an economy into a liquidity trap.
Keywords: liquidity traps; Taylor rules; zero bound on nominal interest rates
JEL Codes: E31; E52; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Nominal interest rates bounded below by zero (E43) | Self-fulfilling expectations of decelerating inflation (E31) |
| Self-fulfilling expectations of decelerating inflation (E31) | Decrease in nominal interest rates (E43) |
| Decrease in nominal interest rates (E43) | Increased demand for real balances (E41) |
| Increased demand for real balances (E41) | Decline in consumption utility (D11) |
| Fiscal policies (H39) | Eliminate liquidity traps (E41) |
| Inflation-sensitive budget surplus schedule (E31) | Prevent low-inflation steady states from being financially sustainable (E31) |
| Increased government deficits in response to low inflation (E62) | Stimulate demand (E65) |
| Stimulate demand (E65) | Raise price levels (E64) |
| Switching from interest rate rule to money growth rate peg (E49) | Avoid liquidity traps (E41) |