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The New-Keynesian Liquidity Trap

In standard solutions, the new-Keynesian model produces a deep recession with deflation in a liquidity trap. The model also makes unusual policy predictions: Useless government spending, technical regress, and capital destruction have large multipliers. These predictions become larger as prices become less sticky. I show that both data and policy predictions are strongly affected by equilibrium selection. For the same interest-rate path, different choices of equilibria – either by the researcher’s direct selection or the researcher’s specification of expected Federal Reserve policy – can overturn all these results. A set of “local-tofrictionless” equilibria predicts mild inflation, no output reduction and negative multipliers during the liquidity trap, and its predictions approach the frictionless model smoothly, all for the same interest rate path.

Authors: 
John Cochrane, Stanford University
Publication Date: 
January, 2015
BFI Initiative: 
Publication Type: