Expectations, Stagnation and Fiscal Policy
Some observers have argued that stagnation may become the new norm. We examine this possibility in a New Keynesian model with agents forming expectations using adaptive learning and consider fiscal policy in this context. We impose inflation and consumption lower bounds, which can be relevant when agents are pessimistic. The targeted steady state is locally stable under learning, but if initial expectations are pessimistic the economy can instead sink into a steady-state stagnation trap. Fiscal multipliers are first examined for an economy near the targeted steady state, and then studied when it is subject to an expectations shock. Following a serious pessimistic expectations shock a sufficiently large fiscal stimulus is needed to avoid or emerge from the stagnation steady state. The probability of avoiding stagnation depends on the size and length of the stimulus and appears to depend critically on how early the policy is employed.