NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The New-Keynesian Liquidity Trap

John H. Cochrane

NBER Working Paper No. 19476
Issued in September 2013, Revised in October 2014
NBER Program(s):Asset Pricing, Economic Fluctuations and Growth, Monetary Economics

In standard solutions, the new-Keynesian model produces a deep recession with deflation in a liquidity trap. The model also makes unusual policy predictions: Useless government spending, technical regress, and capital destruction have large multipliers. These predictions become larger as prices become less sticky. I show that both sets of predictions are strongly affected by equilibrium selection. For the same interest-rate path, different choices of equilibria - either by the researcher's direct selection or the researcher's specification of expected Federal Reserve policy - can overturn all these results. A set of "local-to-frictionless" equilibria predicts mild inflation, no output reduction and negative multipliers during the liquidity trap, and its predictions approach the frictionless model smoothly, all for the same interest rate path.

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Document Object Identifier (DOI): 10.3386/w19476

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