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 data and policy 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-tofrictionless” 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. ∗University of Chicago Booth School of Business, Hoover Institution, NBER, and Cato Institute; [email protected]. I thank Tom Coleman, Bill Dupor, Martin Eichenbaum, Jesús FernándezVillaverde, Miles Kimball, Narayana Kocherlakota, Ed Nelson, Ivan Werning, Johannes Weiland, anonymous referees, and seminar participants for many helpful comments. I thank CRSP and the Guggenheim Foundation for research support. Please do not re-post this paper. Use the link: http://faculty.chicagobooth.edu/john. cochrane/research/papers/zero\protect_bound\protect_2.pdf