UCL Discovery

Abstract

In the basic New Keynesian model in which the monetary authority operates a Taylor rule, multiple rational expectations equilibria arise, some of which display all the features of a liquidity trap. We show that a loss in confidence can set the economy on a deflationary path that eventually prevents the monetary authority from adjusting the interest rate and can lead to potentially very large output drops. Contrary to a line of recent papers, we describe equilibria in which demand stimulating policies become less effective in a liquidity trap than in normal circumstances. In contrast, supply side policies, such as cuts in labor income taxes, become more powerful. We show that these results also hold for local deviations from rational expectations.