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Simple Analytics of Expectations-Driven Liquidity Traps
1 : European Central Bank
We analytically characterize occasional and temporary liquidity trap episodes that are driven by exogenous changes in agents' confidence. The analysis is based on a New Keynesian model with price rigidities, a discretionary central bank, and a two-state sunspot shock. The sunspot equilibrium differs from equilibria with fundamental-driven liquidity traps in several ways: The sunspot equilibrium exists if and only if the state associated with liquidity trap episodes is sufficiently persistent. The sunspot equilibrium does not give rise to the paradox of flexibility. Modifying the objective function of the central bank to include a higher weight on inflation stabilization or a strictly positive inflation target is welfare-reducing.
