Large negative aggregate demand shocks can drive down an economy’s equilibrium real interest rate and if the central bank is committed to stabilizing inflation monetary policy may be hampered by the zero lower bound on nominal interest rates –the economy may be in a 'liquidity trap.' The policy dilemma associated with the zero lower bound has been extensively debated in recent years. Based on the experience of Japan in the 1990’s writers like Krugman (1998) Eggertsson and Woodford (2003 2005) Jung Terinishi and Watanabe (2005) Svensson (2003) Auerbach and Obstfeld (2006) among others explored how monetary policy announcements could be usefully employed even when the authorities have no more room for reducing short-term nominal interest rates. More recently given the 2008-2009 global recession a number of authors have explored the options for fiscal stimulus when the economy is stuck in a liquidity trap. Papers by Christiano Eichenbaum and Rebelo (2009) Eggertsson (2010) Cogan et al. (2009) and Devereux (2010) have investigated the possibility of using government spending expansions and tax cuts when nominal interest rates are at their lower bound.
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