Discussion Paper Series 2025-E-1

Deflationary Equilibrium with Uncertainty

Philip Coyle, Naoki Maezono, Taisuke Nakata, Sebastian Schmidt

We analyze the so-called deflationary equilibrium of the New Keynesian model with an interest rate lower bound when the future course of the economy is uncertain. In the deflationary equilibrium, we find that the rate of inflation is higher at the risky steady state, which takes uncertainty into account, than at the deterministic steady state, which abstracts away from uncertainty. The rate of inflation at the risky steady state can be positive if the target rate set by the central bank is positive. Our theory is consistent with the Japanese experience in the 2010s when the rate of inflation was on average positive while the interest rate lower bound was binding.

Keywords: Effective Lower Bound; Deflationary Equilibrium; Liquidity Trap; Risky Steady State; Uncertainty


Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

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