In standard solutions, the new-Keynesian model produces a deep recession with deflation in a liquidity trap. Useless government spending, technical regress, and capital destruction have large positive multipliers. The recession, deflation and policy paradoxes are larger when prices are less sticky. I show that these features are all artifacts of equilibrium selection. For the same interest-rate...

Prevalent thinking about liquidity traps suggests that the perfect substitutability of money and bonds at a zero short-term nominal interest rate renders open-market operations ineffective for achieving macroeconomic stabilization goals. We show that even were this the case, there remains a powerful argument for large-scale open market operations as a fiscal policy tool. As we also demonstrate,...

We study optimal monetary policy in a NewMonetarist framework with banking, private liquidity, and credit frictions.We show that whenever part of the decentralized transactions are allowed to use deposit claims backed by interest-bearing assets, the optimal policy is a non-Friedman-rule liquidity trap. In contrast, the Friedman rule is optimal if there are no credit frictions, or if the economy...