Learning to Believe in Secular Stagnation

Abstract

This paper shows that a secular stagnation equilibrium as proposed by Eggertsson and Mehrotra (2014) is E-stable. This is in contrast to the often studied liquidity trap equilibrium that exists in representative agent New Keynesian models at the zero lower bound when there is active monetary policy following a Taylor rule. This result reconciles the observed stable low growth and low inflation outcomes since the end of the Global Financial Crisis with the instability predicted by the New Keynesian model using a standard modeling framework. The stability of the secular stagnation equilibrium is due to the assumption of downwardly rigid nominal wages and overlapping generations. At the zero lower bound, the wage friction determines the price level and makes inflation a predetermined variable, while overlapping generations weakens the negative relationship between expected output and the real interest rate.