Should-Read: George W. Evans, Seppo Honkapohja, and Kaushik Mitra: Expectations, Stagnation and Fiscal Policy

Should-Read: George W. Evans, Seppo Honkapohja, and Kaushik Mitra: Expectations, Stagnation and Fiscal Policy: “Persistent stagnation and fiscal policy are examined in a New Keynesian model with adaptive learning determining expectations… http://www.bankofengland.co.uk/research/Documents/conferences/conference03040717/expectationspolicy.pdf

…We impose inflation and consumption lower bounds, which can be relevant when agents are pessimistic. The inflation target is locally but not globally stable un- der learning. Pessimistic initial expectations may sink the economy into steady-state stagnation with deflation. The deflation rate can be near zero for discount factors near one or if credit frictions are present. Following a severe pessimistic expectations shock a large temporary fiscal stimulus is needed to avoid or emerge from stagnation. A modest stimulus is sufficient if implemented early…