The Deflation Bias and Committing to Being Irresponsible

I model deation, at zero nominal interest rate, in a microfounded general equi-librium model. I show that deation can be analyzed as a credibility problem if the government has only one policy instrument, i.e. increasing money supply by open mar-ket operations in short-term bonds, is faced with temporary negative demand shocks and cannot commit to future policies. This is the deation bias of discretionary policy. I propose several policies to solve the deation bias. They involve printing money or issuing nominal debt and either 1) cutting taxes, 2) buying real assets such as stocks, or 3) purchasing foreign exchange. The government credibly commits to being ir-responsible by using these policy instruments. It commits to higher money supply in the future so that the private sector expects ination instead of deation. This is optimal since it curbs deation and increases output by lowering the real rate of return. __________________________ * IMF and the Federal Reserve Bank of New York. I thank Mike Woodford for continuous advise and extensive com-