The New-Keynesian Liquidity Trap
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.
Document Object Identifier (DOI): 10.3386/w19476
Published: John H. Cochrane, 2017. "The new-Keynesian liquidity trap," Journal of Monetary Economics, vol 92, pages 47-63.
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