Date Added: May 2011
Recent research has found that the dynamic properties of the New Keynesian model can be very different when the nominal interest rate is zero. Improvements in technology and reductions in the labor tax rate lower economic activity, and the size of the government purchase output multiplier can be well above one. This paper provides evidence that the focus on specifications of the New Keynesian model that produce unorthodox results in a liquidity trap may be misplaced. The authors show that a prototypical New Keynesian model fit to Japanese data exhibits orthodox dynamics during Japan's episode with zero interest rates. They then demonstrate that this specification is more consistent with outcomes in Japan than alternative specifications that have unorthodox properties.