No. 1080 - Self-fulfilling deflations

What types of monetary and fiscal policy rules produce self-fulfilling deflationary paths that are monotonic and empirically relevant? This paper presents simple theoretical conditions that guarantee the existence of these paths in a general equilibrium model with sticky prices. These sufficient conditions are weak enough to be satisfied by most monetary and fiscal policy rules. A quantification of the model which combines a real shock à la Hayashi and Prescott (2002) with a simultaneous sunspot that deanchors inflation expectations matches the main empirical features of the Japanese deflationary process during the “lost decade”. The results also highlight the key role of the assumption about the anchoring of inflation expectations for the size of fiscal multipliers and, in general, for any policy analysis.

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