(University of Oregon, Dept of Economics, 2007-06-05) Evans, George W., 1949-; Guse, Eran A. (Eran Alan), 1975-; Honkapohja, Seppo, 1951-
We examine 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 aggressive monetary and fiscal policy that guarantee a lower
bound on inflation. In contrast, policies geared toward ensuring an
output lower bound are insufficient for avoiding deflationary spirals.
