Endogenous Persistence at the Effective Lower Bound

TL;DR

This paper introduces a perfect foresight method for solving models with interest rate lower bounds, capable of handling endogenous persistence and matching real-world data from the Great Recession.

Contribution

It generalizes existing solutions by allowing endogenous persistence while ensuring stability and interpretability in models with interest rate constraints.

Findings

Output multiplier of government spending close to 1 for the US and Japan.

Method encompasses and extends previous solutions like OccBin and pen-and-paper approaches.

Successfully matches expectations data from the Great Recession.

Abstract

We develop a perfect foresight method to solve models with an interest rate lower bound constraint that nests OccBin/DynareOBC and \cite{Eggertsson2010}'s as well as \cite{Mertens2014}'s pen and paper solutions as special cases. Our method generalizes the pen-and-paper solutions by allowing for endogenous persistence while maintaining tractability and interpretability. We prove that our method necessarily gives stable multipliers. We use it to solve a New Keynesian model with habit formation and government spending, which we match to expectations data from the Great Recession. We find an output multiplier of government spending close to 1 for the US and Japan.