Discussion of Evans and Honkapohja, “Policy Interaction, Expectations, and the Liquidity Trap”

In-Koo Cho
Working Paper 2003-17
October 2003

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The result of Benhabib, Schmitt-Grohé, and Uribe (2001) is powerful because it relies only on three rather natural conditions: the Fisher equation, the convex Taylor rule, and the lower bound of the nominal interest rate. Their result is striking because the paper reveals the peril of the active Taylor rule, which has been shown to implement the target in a stable manner under various conditions. In a related paper, Benhabib, Schmitt-Grohé, and Uribe (2002) proposed a number of policies designed to avoid the liquidity trap outcome. One is to link government’s spending to the inflation rate. Subject to the intertemporal budget constraint, the government’s taxation on the private sector decreases as the inflation rate drops, causing the budget of the private sector to increase. Consequent increases in aggregate demand and the price level push the economy away from the liquidity trap. This sort of fiscal policy is considered “active” in the sense that the policy can increase the government budget deficit, in contrast to the “passive” fiscal policy which is designed to maintain or lower the budget deficit.

The discussant’s comments were 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 author’s and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author’s responsibility.

Please address questions regarding content to In-Koo Cho, Department of Economics, University of Illinois at Urbana-Champaign, 330 Wohlers Hall, 1206 S. Sixth Street, Champaign, Illinois 61820, 217-333-0120, inkoocho@uiuc.edu.