Fiscal consequences of inflationary policies

The proposal that the Bank of Japan should commit itself to a monetary policy aimed at inducing long-term inflation [Krugman, P., 1998a. Japan's trap. Available from: http://web.mit.edu/krugman/www/ japtrap.html] attracted considerable attention in Japan, since it was thought to imply that no more fiscal stimulation would be necessary and that monetary easing alone could get the economy out of recession. In this paper, I modify the Krugman's model to a three-period model and show that temporary deflation and recession may be aggravated if fiscal policies remain unchanged at the same time as the central bank commits itself to a long-term inflation target.