Deflationary Traps, Agents’ Beliefs and Fiscal-Monetary Policies

Abstract. We study the functioning of a system in the presence of the zero lower bound constraint on the nominal interest rate under the assumption that agents have limited cognitive capabilities. In order to do so, we employ a micro founded 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, 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