Working Paper: CEPR ID: DP2969
Authors: Stephanie Schmitt-Grohe; Martin Uribe
Abstract: A key result of a recent literature that focuses on the global consequences of Taylor-type interest rate feedback rules is that such rules, in combination with the zero-bound on nominal interest rates, can lead to unintended liquidity traps. An immediate question posed by this result is whether the government could avoid liquidity traps by ignoring the zero-bound, that is, by threatening to set the nominal interest rate at a negative value should the inflation rate fall below a certain threshold. This Paper shows that even if the government could credibly commit to setting the interest rate at a negative value, self-fulfilling liquidity traps can still emerge. That is, deflationary equilibria originating arbitrarily near the intended equilibrium and leading to low (possibly zero) interest rates and low (and possibly negative) rates of inflation cannot be ruled out by lifting the zero-bound on the monetary policy rule. This result obtains in models with flexible and sticky prices and under continuous and discrete time.
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 |
|---|---|
| zero bound on nominal interest rates (E43) | emergence of liquidity traps (E41) |
| zero bound on nominal interest rates (E43) | unintended steady states (C62) |
| unintended steady states (C62) | low and possibly negative inflation rates (E31) |
| self-fulfilling liquidity traps (E41) | emergence of liquidity traps (E41) |
| government commitment to negative interest rates (E43) | emergence of liquidity traps (E41) |
| structure of monetary policy (E52) | emergence of liquidity traps (E41) |
| aggressive fiscal policies (E62) | mitigation of liquidity traps (E49) |