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Fiscal Policy in an Expectations-Driven Liquidity Trap

Mertens, KRSM; Ravn, MO; (2014) Fiscal Policy in an Expectations-Driven Liquidity Trap. Review of Economic Studies , 81 (4) pp. 1637-1667. 10.1093/restud/rdu016. Green open access

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Abstract

We study the effects of fiscal policy interventions in a liquidity trap in a model with nominal rigidities and an interest rate rule. In a liquidity trap caused by a self-fulfilling state of low confidence, higher government spending has deflationary effects that reduce the spending multiplier when the zero lower bound is binding. Instead, cuts in marginal labour tax rates are inflationary and become more expansionary when the zero lower bound is binding. These findings contradict a popular view, based on a liquidity trap caused by a fundamental shock such as a taste shock, that higher government spending is inflationary and can therefore be associated with large multipliers at the zero lower bound, while lower marginal tax rates are deflationary and therefore counterproductive.

Type: Article
Title: Fiscal Policy in an Expectations-Driven Liquidity Trap
Open access status: An open access version is available from UCL Discovery
DOI: 10.1093/restud/rdu016
Publisher version: https://doi.org/10.1093/restud/rdu016
Language: English
Additional information: This version is the author accepted manuscript. For information on re-use, please refer to the publisher’s terms and conditions.
UCL classification: UCL
UCL > Provost and Vice Provost Offices > UCL SLASH
UCL > Provost and Vice Provost Offices > UCL SLASH > Faculty of S&HS
UCL > Provost and Vice Provost Offices > UCL SLASH > Faculty of S&HS > Dept of Economics
URI: https://discovery.ucl.ac.uk/id/eprint/10066707
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