Fiscal Policy in an Expectations-Driven Liquidity Trap

Abstract

We study the effects of fiscal policy interventions in a liquidity trap in a model with nominal rigidities and an interest rate rule. In a liquidity trap caused by a self-fulfilling state of low confidence, higher government spending has deflationary effects that reduce the spending multiplier when the zero lower bound is binding. Instead, cuts in marginal labor tax rates are inflationary and become more expansionary when the zero lower bound is binding. These findings contradict popular views about the effects of fiscal policy in a liquidity trap.