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We document a new fact: households do not expect deflation, as seen in survey forecasts in the US, European countries, and Japan. At the same time, deflation does occur in the US and European countries, and very persistent deflation has been observed in Japan and Greece. This fact stands in contrast to the standard macroeconomic models with rational and non-rational expectations alike. We extend the standard New Keynesian model extended with a zero-lower bound on inflation expectations. The model has a unique equilibrium even when the liquidity trap is very persistent. Unconventional monetary policies, such as forward guidance, are weaker. In liquidity traps, the government spending output multiplier is finite, and adverse aggregate supply shocks are not expansionary.
