In the benchmark New Keynesian (NK) model, I introduce the real cost channel to study government spending multipliers and provide simple Markov chain closed-form solutions. This model departs fundamentally from most previous interpretations of the nominal cost channel by flattening the NK Phillips Curve in liquidity traps. At the zero lower bound, I show analytically that following positive government spending shocks, the real cost channel can make inflation rise less than in a model without this channel. This then causes a smaller drop in real interest rates, resulting in a lower output gap multiplier. Finally, I confirm the robustness of the real cost channel’s effect on multipliers using extensions of two models.

Multiple equilibria arise in standard New Keynesian models when the nominal interest rate is set according to the Taylor rule and constrained by a zero lower bound (ZLB). One of these equilibria is deflationary and referred to as an expectations-driven liquidity trap (ELT) as it arises because of the de-anchoring of inflation expectations. This study demonstrates that a simple tax rule responding to inflation can prevent a liquidity trap from arising without increasing government spending or debt. We analytically investigate the necessary and sufficient conditions to prevent an ELT and show that both the frequency and persistence of ELT episodes affect the extent to which the tax rule must respond to inflation. In brief, the higher the frequency or the longer the persistence of the ELT, the greater the response of the tax rate must be.

This paper analyzes a regime-switching New Keynesian model to understand what happens to the aggregate economy when the nominal interest rate hits the zero lower bound (ZLB). Contrary to the literature, our model predicts that the aggregate demand curve is not always upward sloping when the ZLB binds. Instead, it depends on expectations. If the expected duration of the ZLB is short but consistent with expectations surveys, the AD curve can be downward sloping. In that case, the fiscal multiplier is moderate and supply-side reforms are expansionary. These results complement existing findings in the literature.

In this paper, I examine the role of government spending persistence on fiscal multipliers at the zero lower bound (ZLB) in a more realistic environment while keeping the model simple enough to identify mechanisms driving the result. In particular, I build on a standard dynamic New Keynesian (DNK) model with an occasionally binding ZLB and Rotemberg pricing with rebates, where the probability of hitting the ZLB and the government purchase shock are in line with US data. Moreover, I compute the multiplier in a state that mimics the Great Recession. The main findings of the paper are as follows: (1) the multiplier is non-monotonic in the persistence of government spending while the economy is at the ZLB; (2) given the persistence estimated from US data, the multiplier is 1.25; and (3) in the framework with perfect foresight or with aggregate resource cost for adjusting prices, the multiplier is around 1 or less.

The period of low interest rates since the global financial crisis provides a unique opportunity to examine monetary policy reaction functions near the zero lower bound (ZLB). Using smooth transition regressions for the Euro area and a panel of industrialized countries we show that central banks anticipate the ZLB by less aggressive policies in its vicinity while we do not find a significant difference between both regimes for the US.

In this paper, we analyze the relationship between unconventional monetary policy (UMP), measured through shadow interest rates, and housing markets for the USA, the United Kingdom, Japan, and the Euro Area using a set of time-varying parameter vector autoregressive models. Our findings suggest that the monetary policy transmission mechanism to the housing market has not changed with the implementation of quantitative easing or forward guidance for most economies considered. A counterfactual exercise provides some evidence that UMP has been particularly successful in dampening the consequences of the financial crisis on housing markets in the USA, while the effects are more muted in the remaining countries considered.

We examine “Forward Guidance Contracts,” which penalize central bankers for choosing high interest rates. We integrate those contracts into the New Keynesian Framework and show that they can be used to overcome a liquidity trap. Moreover, although the government takes only a share of the social benefits into account when it has to decide whether to offer the contract, we demonstrate that for plausible parameter values the government will always find it desirable to offer the contract in a liquidity trap but not in normal times. Finally, we show that the optimal duration of such contracts is typically very short.

Some recent empirical evidence questions the typically large size of government spending multipliers when the nominal interest rate is stuck at zero, finding output multipliers of around 1 or even lower, with an upper bound of around 1.5 in some circumstances. In this paper, we use a recent estimate of the degree of substitutability between private and government consumption in an otherwise standard New Keynesian model to show that this channel significantly reduces the size of government spending multipliers obtained when the nominal interest rate is at zero. All else being equal, the relationship of substitutability makes a government spending shock crowd out private consumption while being less inflationary, thus, limiting the typically expansionary effect of the fall in the real interest rate. Subject to the nominal interest rate being constrained at zero, the model generates output multipliers ranging from 0.8 to 1.6.

The paper revisits the literature on real rigidities in New Keynesian models in the context of an economy at the zero lower bound. It identifies strategic interaction among price- and wage-setting agents in the economy as an important determinant of both optimal policy and economic dynamics in deep recessions. In particular, labor market segmentation is shown to have a significant influence on the length of the forward commitment to keep interest rates at zero, the magnitude of the fiscal policy responses as well as inflation volatility in the economy under optimal policy.

I examine the optimal inflation target in a dynamic stochastic New Keynesian model featuring an occasionally binding zero lower bound on nominal interest rate (ZLB). To this end, I first calibrate the shock needed to generate the risk of hitting the ZLB that matches the U.S. data, based on a fully nonlinear method. I then resolve the model with different inflation targets and find that the optimal target is 3.4%. In addition, the optimal inflation target is a nonlinear function of the risk of hitting the ZLB and inflation indexation. It is always greater than 2% if the risk is greater than 2.5% or if the inflation indexation is higher than 0.5. Finally, the linear–quadratic approach overestimates the true optimal inflation target. In particular, based on the benchmark calibration, it generates an optimal target of 5.5%, compared with 3.4% found by the fully nonlinear method.

This paper examines the outcomes for changes introduced by the UK Coalition government in 2010. The Office for Budget Responsibility (OBR) is generally regarded as a success, and should become a permanent part of fiscal policymaking. The form of the primary fiscal mandate, involving a five-year rolling target, appears to be a sensible way to shape fiscal decisions when monetary policy is able to stabilise the economy. Unfortunately it was introduced, along with a five-year programme of severe fiscal consolidation (austerity), while the economy was in a liquidity trap. The OBR estimates austerity reduced GDP growth by 1 per cent in both 2010–11 and 2011–12, and monetary policy was unable to offset this. For the Liberal Democrats a misreading of the Eurozone crisis may have been responsible for this mistake, but for the Conservatives this mistake appears to derive from an unconventional view that the liquidity trap is unimportant.