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UNANCHORED EXPECTATIONS: SELF-REINFORCING LIQUIDITY TRAPS AND MULTIPLE STEADY STATES

Published online by Cambridge University Press:  03 October 2019

Joep Lustenhouwer*
Affiliation:
Otto-Friedrich-Universität Bamberg
*
Address correspondence to: Joep Lustenhouwer, Otto-Friedrich-Universität Bamberg, Feldkirchenstraße 21, 96052 Bamberg, Germany. e-mail: joep.lustenhouwer@uni-bamberg.de. Phone: +49-951-863-2580.
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Abstract

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We study a New Keynesian model with bounded rationality, where agents choose their expectations heterogeneously from a discrete choice set. The range of their set of possible expectation values can be interpreted as the anchoring of expectations. In the model, multiple locally stable steady states can arise that reflect coordination on particular expectation values. Moreover, bad shocks to the economy can trigger a self-reinforcing wave of pessimism, where the zero lower bound on the nominal interest rate becomes binding, and agents coordinate on a locally stable liquidity trap steady state. When we let the anchoring of expectations evolve endogenously, it turns out that the anchoring of expectations at the time the bad shocks hit the economy is crucial in determining whether the economy can recover from the liquidity trap. Finally, we find that a higher inflation target makes it less likely that self-reinforcing liquidity traps arise.

Type
Articles
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted re-use, distribution, and reproduction in any medium, provided the original work is properly cited.
Copyright
© Cambridge University Press 2019

Footnotes

The author gratefully acknowledges the financial support of NWO (Dutch Science Foundation) Project No. 40614011 “Monetary and Fiscal Policy under Bounded Rationality and Heterogeneous Expectations”.

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