Mathematical analysis

Microeconomics

Taylor rule

Central bank

Dynamic stochastic general equilibrium

Business cycle

Monetary policy

Economics

Market liquidity

Physics

Incomplete markets

Liquidity risk

Mathematics

Macroeconomics

Monetary economics

Quantum mechanics

New Keynesian economics

Indeterminacy (philosophy)

Liquidity trap

Keynesian economics

Determinacy

Econometrica

Using an analytically tractable heterogeneous agent New Keynesian model, we show that whether incomplete markets resolve New Keynesian “paradoxes” depends on the cyclicality of income risk. Incomplete markets reduce the effectiveness of forward guidance and multipliers in a liquidity trap only with procyclical risk. Countercyclical risk amplifies these “puzzles.” Procyclical risk permits determinacy under a peg; countercyclical risk may generate indeterminacy even under the Taylor principle. By affecting the cyclicality of risk, even “passive” fiscal policy influences the effects of monetary policy.

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