Unconventional Policies in State-Dependent Liquidity Traps

Tayler, William J. and Zilberman, Roy (2024) Unconventional Policies in State-Dependent Liquidity Traps. Journal of Economic Dynamics and Control, 168: 104956. ISSN 0165-1889

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Abstract

We characterize optimal unconventional monetary and fiscal-financial policies against supply- and demand-driven liquidity traps within a tractable New Keynesian model featuring a cash-in-advance constraint and a monetary policy cost channel. Deposit subsidies circumvent the inflation-output trade-off arising from stagflationary shocks and supply-driven liquidity traps by enabling negative nominal interest rates. Additionally, deposit taxes facilitate modest interest rate hikes to escape demand-driven deflationary traps. Notably, discretionary and commitment policies with deposit taxes / subsidies deliver virtually equivalent welfare gains, rendering time-inconsistent forward guidance schedules unnecessary. We also derive robust and implementable optimal policy rules when the sources of shocks are unknown.