Tax Rules to Prevent Expectations-Driven Liquidity Traps

Abstract

Multiple equilibria arise in standard New Keynesian models when the nominal interest rate is set according to the Taylor rule and constrained by a zero lower bound (ZLB). One of these equilibria is deflationary and referred to as an expectations-driven liquidity trap (ELT) as it arises because of the de-anchoring of inflation expectations. This study demonstrates that a simple tax rule responding to inflation can prevent a liquidity trap from arising without increasing government spending or debt. We analytically investigate the necessary and sufficient conditions to prevent an ELT and show that both the frequency and persistence of ELT episodes affect the extent to which the tax rule must respond to inflation. In brief, the higher the frequency or the longer the persistence of the ELT, the greater the response of the tax rate must be.

Expectations-Driven Liquidity Traps: Implications for Monetary and Fiscal Policy

“…Schmidt (2016) shows that it is possible to design Ricardian government spending rules that insulate the economy from expectations-driven liquidity traps. Tamanyu (2019) provides a similar analysis for the case of tax rules. Armenter (2018) shows that augmenting the objective function of a discretionary central bank with an objective for stabilizing the level of a long-run nominal interest rate can ensure the existence of a unique Markov-perfect equilibrium.…”