A new paper from a colleague (along with coauthors, Jess Benhabib and Seppo Honkapohja):
Liquidity Traps and Expectation Dynamics: Fiscal Stimulus or Fiscal Austerity?, by Jess Benhabib, George W. Evans, and Seppo Honkapohja, NBER Working Paper No. 18114, Issued in May 2012: We examine global dynamics under infinite-horizon learning in New Keynesian models where the interest-rate rule is subject to the zero lower bound. As in Evans, Guse and Honkapohja (2008), the intended steady state is locally but not globally stable. Unstable deflationary paths emerge after large pessimistic shocks to expectations. For large expectation shocks that push interest rates to the zero bound, a temporary fiscal stimulus or a policy of fiscal austerity, appropriately tailored in magnitude and duration, will insulate the economy from deflation traps. However "fiscal switching rules" that automatically kick in without discretionary fine tuning can be equally effective.
However, for austerity to work "requires the fiscal austerity period to be sufficiently long, and the degree of initial pessimism in expectations to be relatively mild." That is, the policy must be left in place for a considerable period of time, and if there is expected deflation or an expected decline in output of sufficient magnitude, austerity is unlikely to be effective. The conditions for fiscal stimulus to work are not as stringent, so it is more likely to be effective, but even so "One disadvantage of fiscal stimulus and fiscal austerity policies is that both their magnitude and duration have to be tailored to the initial expectations, so they require swift and precise discretionary action."
Because of this, they suggest fiscal switching as the best policy. Under this policy the government keeps government spending (and taxes) constant so long as expected inflation exceeds a predetermined lower bound. But if expected inflation falls below the threshold, then government spending is increased enough to achieve an output level where actual inflation exceeds expected inflation. Thus, a rule that credibly promises strong fiscal action if expectations become pessimistic can avoid the bad equilibrium in these models. As they note:
Two further points should be noted about this form of fiscal policy. First, it is not necessary to decide in advance the magnitude and duration of the fiscal stimulus. Second, in contrast to the preceding section we now do not assume that agents know the future path of government spending.
In summary, our analysis suggests that one policy that might be used to combat stagnation and deation, in the face of pessimistic expectations, would consist of a fiscal switching rule combined with a Taylor-type rule for monetary policy. The fi scal switching rule applies when ination expectations falls below a critical value. The rule speci fies increased government spending to raise inflation above ination expectations in order to ensure that ination is gradually increased until expected ination exceeds the critical threshold. This part of the policy eliminates the unintended steady state and makes sure that the economy does not get stuck in a regime of deflation and stagnation. Furthermore, unlike the temporary fi scal policies discussed in the previous section, the switching rules do not require fine tuning and are triggered automatically. Remarkably, our simulations indicate that this combination of policies is successful regardless of whether the households are Ricardian or non-Ricardian.