Policy Interaction, Expectations, and the Liquidity Trap

George W. Evans and Seppo Honkapohja
Working Paper 2003-16
October 2003

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The authors consider inflation and government debt dynamics when monetary policy employs a global interest rate rule and private agents forecast using adaptive learning. Because of the zero lower bound on interest rates, active interest rate rules are known to imply the existence of a second, low inflation steady state, below the target inflation rate. Under adaptive learning dynamics the authors find the additional possibility of a liquidity trap, in which the economy slips below this low inflation steady state and is driven to an even lower inflation floor that is supported by a switch to an aggressive money supply rule. Fiscal policy alone cannot push the economy out of the liquidity trap. However, raising the threshold at which the money supply rule is employed can dislodge the economy from the liquidity trap and ensure a return to the target equilibrium.

JEL classification: E63, E52, E58

Keywords: learning, deflation, economic policy

Financial support from the U.S. National Science Foundation, the Academy of Finland, Yrjö Jahnsson Foundation, Bank of Finland and Nokia Group is gratefully acknowledged. We thank In-Koo Cho, Noah Williams, and the participants in the Federal Reserve Bank of Atlanta Conference on Monetary Policy and Learning for their comments. This paper was presented at the Monetary Policy and Learning Conference sponsored by the Federal Reserve Bank of Atlanta in March 2003. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to George W. Evans, Department of Economics, University of Oregon, 1285 University of Oregon, Eugene, Oregon 97403, 541-346-4662, 541-346-1243 (fax), gevans@oregon.uoregon.edu, or Seppo Honkapohja, Department of Economics, University of Helsinki, P.O. Box 54, FIN-00014 Helsinki, Finland, 358 9 1912 4876, 358 9 1912 4877 (fax), seppo.honkapohja@helsinki.fi.