Working Paper: CEPR ID: DP6355
Authors: George W. Evans; Eran Guse; Seppo Honkapohja
Abstract: We examine global economic dynamics under learning in a New Keynesian model in which the interest-rate rule is subject to the zero lower bound. Under normal monetary and fiscal policy, the intended steady state is locally but not globally stable. Large pessimistic shocks to expectations can lead to deflationary spirals with falling prices and falling output. To avoid this outcome we recommend augmenting normal policies with aggressive monetary and fiscal policy that guarantee a lower bound on inflation. In contrast, policies geared toward ensuring an output lower bound are insufficient for avoiding deflationary spirals.
Keywords: adaptive learning; fiscal policy; indeterminacy; monetary policy; zero interest rate lower bound
JEL Codes: E52; E58; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| normal monetary and fiscal policy (E63) | intended steady state stability (C62) |
| large pessimistic shocks to expectations (D84) | instability of steady state (C62) |
| instability of steady state (C62) | deflationary spirals (E31) |
| aggressive monetary and fiscal measures (E63) | prevention of deflationary spirals (E31) |
| inflation threshold policy (E31) | stabilization of economy (E63) |
| output threshold policy (L21) | insufficient response to deflationary pressures (E31) |
| early implementation of inflation threshold policies (E31) | mitigation of adverse effects of expectation shocks (D84) |