Lack of confidence, the zero lower bound, and the virtue of fiscal rules

In the presence of the zero lower bound, standard business cycle models with a Taylor-type monetary policy rule are prone to equilibrium multiplicity. A drop in private sector confidence can drive the economy into a liquidity trap without any change in fundamentals. I show, in the context of a standard New Keynesian model, that it is possible to design Ricardian fiscal spending rules that insulate the economy from such expectations-driven liquidity traps. In the case of price adjustment costs, desirable fiscal rules ensure that a drop in confidence does not lead to a decline in real marginal costs. In the case of nominal wage adjustment costs, desirable fiscal spending rules ensure that a drop in confidence does not lead to a decline in the ratio of the marginal rate of substitution between private consumption and hours worked relative to the real wage rate.