Working Paper: CEPR ID: DP9176
Authors: Jess Benhabib; George W. Evans; Seppo Honkapohja
Abstract: We examine global dynamics under infinite-horizon learning in New Keynesian models where the interest-rate rule is subject to the zero lower bound. As in Evans, Guse and Honkapohja (2008), the intended steady state is locally but not globally stable. Unstable deflationary paths emerge after large pessimistic shocks to expectations. For large expectation shocks that push interest rates to the zero bound, a temporary fiscal stimulus or a policy of fiscal austerity, appropriately tailored in magnitude and duration, will insulate the economy from deflation traps. However "fiscal switching rules" that automatically kick in without discretionary fine tuning can be equally effective.
Keywords: adaptive learning; monetary policy; fiscal policy; zero interest 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 |
|---|---|
| Large pessimistic expectation shocks (D84) | Deflation trap (E31) |
| Expectations (D84) | Economic outcomes (F69) |
| Temporary fiscal stimulus (E62) | Intended steady state (D50) |
| Fiscal stimulus (E62) | Convergence to intended steady state (C62) |
| Fiscal austerity (E62) | Intended steady state (D50) |
| Fiscal austerity (E62) | Convergence to intended steady state (C62) |