Working Paper: NBER ID: w19476
Authors: John H. Cochrane
Abstract: In standard solutions, the new-Keynesian model produces a deep recession with deflation in a liquidity trap. The model also makes unusual policy predictions: Useless government spending, technical regress, and capital destruction have large multipliers. These predictions become larger as prices become less sticky. I show that both sets of predictions are strongly affected by equilibrium selection. For the same interest-rate path, different choices of equilibria - either by the researcher's direct selection or the researcher's specification of expected Federal Reserve policy - can overturn all these results. A set of "local-to-frictionless" equilibria predicts mild inflation, no output reduction and negative multipliers during the liquidity trap, and its predictions approach the frictionless model smoothly, all for the same interest rate path.
Keywords: New Keynesian; Liquidity Trap; Equilibrium Selection; Fiscal Policy; Inflation
JEL Codes: E12; E3; E4; E6
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Equilibrium choice (D59) | Predicted output and inflation levels (E31) |
| Equilibrium choice (D59) | Effectiveness of fiscal policy (E62) |
| Expectations about future interest rates and inflation (E43) | Equilibrium selection (C62) |
| Equilibrium selection (C62) | Economic outcomes (F69) |
| Equilibrium choice (D59) | Economic policy implications (F68) |