Monetary and Fiscal Policy under Learning in the Presence of a Liquidity Trap

This paper reports on the findings of Evans, Guse, and Honkapohja (2007) concerning the global economic dynamics under learning in a New Keynesian model in which the interest rate rule is subject to the zero lower bound. Under normal monetary and fiscal policy, the intended steady state is locally but not globally stable. Large pessimistic shocks to expectations can lead to deflationary spirals with falling prices and falling output. To avoid this outcome, we recommend augmenting normal policies with inflation threshold policies: if under normal policies inflation would fall below a suitably chosen threshold, these policies should be replaced by aggressive monetary and fiscal policies that guarantee this lower bound on inflation.