A NOTE ON THE SLOPE OF THE AGGREGATE DEMAND CURVE AT THE ZERO LOWER BOUND

What is it about?

The zero lower bound (ZLB) is a policy constraint that arises when nominal interest rates reach zero and cannot be lowered any further to stimulate the economy. One of the key assumptions in macroeconomic models is that the aggregate demand (AD) curve slopes upward at the ZLB, meaning that higher inflation stimulates rather than depresses demand. However, this assumption has been challenged by some studies that have observed discrepancies between theory and actual outcomes. To better understand the implications of the ZLB, this paper examines a modified version of the new Keynesian model that incorporates a regime-switching approach. Our model suggests that the slope of the AD curve depends on people's expectations about the duration of the ZLB. If people expect the ZLB to be temporary, the AD curve may slope downward, meaning that higher inflation depresses rather than stimulates demand. This is because people will take into account the long-term impact of their choices, such as the potential switch to a normal state with a Taylor-type interest rate rule. To describe transitions between the two states – one with a binding ZLB and one with a normal interest rate rule – we use a Markov process. Our results show that the AD curve slopes downward when the likelihood of transitioning from a normal state to another is high and the likelihood of transitioning from a ZLB state to another is low – a finding that is corroborated by empirical studies. Additionally, we find that the bigger the reaction to inflation in the normal state, the more probable it is for the AD curve to be downward-sloping in the ZLB state. Our findings offer new insights into the behavior of the AD curve at the ZLB and the potential effectiveness of macroeconomic policies. For example, if the economy operates in the downward region of the AD curve, we find that the fiscal multiplier is moderate, and supply-side reforms are expansionary. This indicates that the effectiveness of fiscal and supply-side policies may depend on people's expectations about the duration of the ZLB. Overall, this paper emphasizes the importance of expectations in a two-state policy environment and provides a different view of the ZLB than previous studies. Assessing the effects of policy in a liquidity trap with dynamic stochastic general equilibrium (DSGE) models can be quite challenging, and our results offer a new perspective on this issue.

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Photo by Zwaddi on Unsplash

Photo by Zwaddi on Unsplash