We study optimal time-consistent monetary and fiscal policy in a New Keynesian model where occasional declines in agents' confidence give rise to persistent liquidity trap episodes. Insights from widely studied fundamental-driven liquidity traps are not a useful guide for enhancing welfare in this model. Raising the inflation target, appointing an inflation-conservative central banker, or allowing for the use of government spending as an additional stabilization tool can exacerbate deflationary pressures and demand deficiencies during the liquidity trap episodes. However, appointing a policy-maker who is sufficiently less concerned with government spending stabilization than society eliminates expectations-driven liquidity traps.
Nakata, Taisuke, and Sebastian Schmidt.
"Expectations-Driven Liquidity Traps: Implications for Monetary and Fiscal Policy."
American Economic Journal: Macroeconomics,
Price Level; Inflation; Deflation
Policy Objectives; Policy Designs and Consistency; Policy Coordination
Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy