Abstract
Standard New Keynesian models deliver puzzling results at the effective lower bound of short-term interest rates: greater price flexibility amplifies the fall in the output gap in response to adverse demand shocks; labour tax cuts are contractionary; the multiplier of wasteful government spending is large. These outcomes stem from a failure to characterise monetary policy correctly. Both analytically and numerically, we show that allowing the central bank to respond to inflation with quantitative easing can resolve all these paradoxes. In quantitative terms, mild adjustments to the central bank’s balance sheet are sufficient to obtain results more in line with conventional wisdom.
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