Escaping the Great Recession

While high uncertainty is an inherent implication of entering the zero lower bound, deflation is not, because agents are likely to be uncertain about the way policy makers will deal with the large stock of debt arising from a severe recession. We draw this conclusion based on a standard new-Keynesian model in which policy makers' behavior can move between a Monetary and a Fiscally led regime and zero lower bound episodes are recurrent. Given that policy makers' behavior is constrained at the zero lower bound, beliefs about the exit strategy play a key role. Announcing a period of austerity is detrimental in the short run, but it preserves macroeconomic stability in the long run. A large recession can be avoided by abandoning fiscal discipline, but this results into a sharp increase in macroeconomic instability once out of the recession. Contradictory announcements by the fiscal and monetary authorities can lead to high inflation and large output losses. However, the policy makers' dilemma can be resolved by committing to inflate away only the portion of debt resulting from an unusually large recession.