The Role of Nonlinearity in Indeterminate Models: An Application to Expectations-Driven Liquidity Traps

Author: Yoichiro Tamanyu
Date: 2020/11/28
No: DP2020-023
JEL Classification codes: C62, C63, E31
Language: English
[ Abstract / Highlights ]

This paper proposes a novel methodology to derive nonlinear solutions of an indeterminate DSGE model in which the decision rules are affected by sunspot shocks. We apply the method to an expectations-driven liquidity trap---a liquidity trap that arises because of the zero lower bound constraint on the nominal interest rate and the de-anchoring of economic agents' expectations---and find that the model dynamics exhibit significant nonlinearity. Such nonlinearity arises because the zero lower bound ceases to bind once the inflation rate rises because of a temporary increase in inflation expectations.