The New-Keynesian Liquidity Trap

January 2015
John Cochrane

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.

Publication Type: 
Working Paper