Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/130687 
Year of Publication: 
2014
Series/Report no.: 
Working Paper No. 2014-17
Publisher: 
Federal Reserve Bank of Chicago, Chicago, IL
Abstract: 
While high uncertainty is an inherent implication of the economy entering the zero lower bound, deflation is not, because agents are likely to be uncertain about the way policymakers will deal with the large stock of debt arising from a severe recession. We draw this conclusion based on a new-Keynesian model in which the monetary/fiscal policy mix can change over time and zero-lower-bound episodes are recurrent. Given that policymakers' behavior is constrained at the zero lower bound, beliefs about the exit strategy play a key role. Announcing a period of austerity is detrimental in the short run, but it preserves macroeconomic stability in the long run. A large recession can be avoided by abandoning fiscal discipline, but this results in a sharp increase in macroeconomic instability once the economy is out of the recession. Contradictory announcements by the fiscal and monetary authorities can lead to high inflation and large output losses. The policy trade-off can be resolved by committing to inflate away only the portion of debt resulting from an unusually large recession.
Subjects: 
policy uncertainty
macroeconomic uncertainty
Markov-switching models
shock-specific policy rules
zero lower bound
JEL: 
E31
E52
E62
E63
D83
Document Type: 
Working Paper

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