Deflationary traps, agents’ beliefs and fiscal–monetary policies

De Grauwe, Paul ORCID: 0000-0001-5225-1301 and Foresti, Pasquale (2025) Deflationary traps, agents’ beliefs and fiscal–monetary policies. Economic Theory. ISSN 0938-2259

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Abstract

We study the role of agents’ limited cognitive capabilities, combined with fiscal and monetary policies, in the generation of a deflationary trap. In order to do so, we employ a heterogeneous expectations New Keynesian model in which the agents’ forecasts are based on simple heuristics. Thanks to a learning mechanism, the model is able to generate endogenous changes in agents’ beliefs that we prove to have a crucial role in the characterization of a deflationary trap. We show that the probability of hitting the zero lower bound on the interest rate, and potentially entering a deflationary trap, is not only affected by the inflation target set by the central bank. This probability is also influenced by the governments’ focus on public debt stabilization and by the agents’ memory and willingness to learn. We also show that the impact of these factors is very significant for inflation targets in the range 0–3%, while an inflation target of 4% isolates the system from the zero lower bound problem.

Item Type:	Article
Additional Information:	© The Author(s) 2025.
Divisions:	European Institute
Subjects:	H Social Sciences > HB Economic Theory
JEL classification:	E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy (Targets, Instruments, and Effects) E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy Formation, Macroeconomic Aspects of Public Finance, Macroeconomic Policy, and General Outlook > E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination F - International Economics > F3 - International Finance > F33 - International Monetary Arrangements and Institutions F - International Economics > F3 - International Finance > F36 - Financial Aspects of Economic Integration
Date Deposited:	15 Apr 2025 09:33
Last Modified:	15 Apr 2025 16:03
URI:	http://eprints.lse.ac.uk/id/eprint/127946

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