The New-Keynesian Liquidity Trap
In standard solutions, the new-Keynesian model produces a deep recession with deflation in a liquidity trap. Useless government spending, technical regress, and capital destruction have large positive multipliers. The recession prediction, and deflation and policy paradoxes are larger when prices are less sticky. I show that these puzzling predictions are artifacts of equilibrium selection. For the same interest-rate policy, different choices of multiple equilibria overturn all these results. A "local-to-frictionless" equilibrium, for the same interest rate policy, predicts mild inflation, no output reduction and negative multipliers during the liquidity trap, and its predictions approach the frictionless model smoothly.
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