Working Paper: CEPR ID: DP7397
Authors: George W. Evans; Seppo Honkapohja
Abstract: We examine global economic dynamics under infinite-horizon learning in a New Keynesian model in which the interest-rate rule is subject to the zero lower bound. As in Evans, Guse and Honkapohja (2008), we find that under normal monetary and fiscal policy the intended steady state is locally but not globally stable. Unstable deflationary paths can arise after large pessimistic shocks to expectations. For large expectation shocks pushing interest rates to the zero lower bound, temporary increases in government spending can be used to insulate the economy from deflation traps.
Keywords: Adaptive Learning; Fiscal Policy; 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 |
|---|---|
| Expectation shocks (D84) | Low output (E23) |
| Expectation shocks (D84) | Deflation (E31) |
| Low output (E23) | Pessimistic expectations (D84) |
| Pessimistic expectations (D84) | Low output (E23) |
| Pessimistic expectations (D84) | Deflation (E31) |
| Temporary increases in government spending (E62) | Insulate economy from deflation traps (E31) |
| Aggressive monetary easing (E52) | Risk of deflation traps (E31) |