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Fiscal Stimulus In Expectations-Driven Liquidity Traps

Lustenhouwer, Joep

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Abstract

I study liquidity traps in a model where 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.

Item Type: Working paper
Series Name: Discussion Paper Series / University of Heidelberg, Department of Economics
Volume: 0683
Place of Publication: Heidelberg
Date Deposited: 14 May 2020 14:28
Date: May 2020
Number of Pages: 60
Faculties / Institutes: The Faculty of Economics and Social Studies > Alfred-Weber-Institut for Economics
Subjects: 330 Economics
Uncontrolled Keywords: bounded rationality; fiscal policy; liquidity trap; heterogeneous expectations
Schriftenreihe ID: Discussion Paper Series / University of Heidelberg, Department of Economics
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