Heterogeneous Expectations, Optimal Monetary Policy, and the Merit of Policy Inertia

Journal of Economic Behavior & Organization

2020

I study liquidity traps in a model were agents have heterogeneous expectations and finite planning horizons. Backward-looking agents base their expectations on past observations, while forward-looking agents have fully rational expectations. Liquidity traps that are fully or partly driven by expectations can arise due to pessimism of backward-looking agents. Only when planning horizons are finite, these liquidity traps can be of longer duration without ending up in a deflationary spiral. I further find that fiscal stimulus in the form of an increase in government spending or a cut in consumption taxes can be very effective in mitigating the liquidity trap. A feedback mechanism of heterogeneous expectations causes fiscal multipliers to be the largest when the majority of agents is backward-looking but there also is a considerable fraction of agents that are forward-looking. Labor tax cuts are always deflationary and are not an effective tool in a liquidity trap.

Section: Introductionsupporting

confidence: 58%

“…Branch and McGough (2010) and Gasteiger (2014) and others refer to these expectations as adaptive expectations. Expectations about output, inflation, debt, the nominal interest rate, taxes and price dispersion are formed analogously.…”

Section: Expectationsmentioning

confidence: 99%

Fiscal stimulus in expectations-driven liquidity traps

Journal of Economic Behavior & Organization

2020

“…Our model is further related to the heterogeneous expectation models of Branch and McGough (2010), Massaro (2013), Gasteiger (2014) and Di Bartolomeo et al (2015).…”

Section: Introductionmentioning

confidence: 99%

Managing unanchored, heterogeneous expectations and liquidity traps

Hommes

Journal of Economic Dynamics and Control

2019

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. AbstractWe study the possibility of (almost) self-fulfilling waves of pessimism and selfreinforcing liquidity traps in a New Keynesian model with heterogeneous expectations. We explicitly focus on the "anchoring" of expectations that is modeled as the range of deviations from the central bank targets (and from the rational expectation equilibrium) that agents are willing to consider. We find that when the zero lower bound on the nominal interest rate is not binding, aggressive monetary policy can prevent waves of pessimism and exclude near unit root dynamics, even when expectations are unanchored. However, as shocks bring the economy to a situation with a binding zero lower bound, there is a danger of a long lasting self-reinforcing liquidity trap that arises because of the existence of multiple steady states. It turns out that in a model where the anchoring of expectations evolves endogenously, the anchoring of expectations at the time the bad shocks hit is crucial in determining whether the economy can recover from the liquidity trap. Furthermore, a higher inflation target reduces the probability that self-reinforcing liquidity traps arise. JEL Classification: E52, E32, C62

“…Our model is further related to the heterogeneous expectation models of Branch and McGough (2010), Massaro (2013), Gasteiger (2014), Di Bartolomeo et al (2016), De Grauwe and Ji (2019), and Hommes and Lustenhouwer (2019a). These papers, however, assume that agents can choose between two expectation formation rules, rather than a distribution of heterogeneous expectations.…”

Section: Introductionmentioning

confidence: 99%

Unanchored Expectations: Self-Reinforcing Liquidity Traps and Multiple Steady States

2019

Macroecon. Dynam.

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.