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Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank

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  • Olivier Jeanne
  • Lars E. O. Svensson

Abstract

Central banks target CPI inflation; independent central banks are concerned about their balance sheet and the level of their capital. The first fact makes it difficult for a central bank to implement the optimal escape from a liquidity trap, because it undermines a commitment to overshoot the inflation target. We show that the second fact provides a solution. Capital concerns provide a mechanism for an independent central bank to commit to inflate ex post. The optimal policy can take the form of a currency depreciation combined with a crawling peg, a policy advocated by Svensson as the "Foolproof Way" to escape from a liquidity trap. (JEL E31, E52, E58, E62)

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Bibliographic Info

Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 97 (2007)
Issue (Month): 1 (March)
Pages: 474-490

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Handle: RePEc:aea:aecrev:v:97:y:2007:i:1:p:474-490

Note: DOI: 10.1257/aer.97.1.474
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  1. Christopher A. Sims, 2001. "Fiscal Aspects of Central Bank Independence," CESifo Working Paper Series 547, CESifo Group Munich.
  2. Peter Stella, 1997. "Do Central Banks Need Capital?," IMF Working Papers 97/83, International Monetary Fund.
  3. Paul R. Krugman, 1998. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 137-206.
  4. Alan J. Auerbach & Maurice Obstfeld, 2005. "The Case for Open-Market Purchases in a Liquidity Trap," American Economic Review, American Economic Association, vol. 95(1), pages 110-137, March.
  5. Scott Roger & Mark R. Stone, 2005. "On Target? the International Experience with Achieving Inflation Targets," IMF Working Papers 05/163, International Monetary Fund.
  6. Gauti B. Eggertsson, 2003. "How to Fight Deflation in a Liquidity Trap," IMF Working Papers 03/64, International Monetary Fund.
  7. John Hawkins, 2003. "Central bank balance sheets and fiscal operations," BIS Papers chapters, in: Bank for International Settlements (ed.), Fiscal issues and central banking in emerging economies, volume 20, pages 71-83 Bank for International Settlements.
  8. Philippe Aghion & Philippe Bacchetta & Abhijit Banerjee, 2000. "Currency Crises and Monetary Policy in an Economy with Credit Constraints," Working Papers 00.07, Swiss National Bank, Study Center Gerzensee.
  9. Lars E.O. Svensson, 2003. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," Journal of Economic Perspectives, American Economic Association, vol. 17(4), pages 145-166, Fall.
  10. Grilli, Vittorio U., 1986. "Buying and selling attacks on fixed exchange rate systems," Journal of International Economics, Elsevier, vol. 20(1-2), pages 143-156, February.
  11. Edwin M. Truman, 2003. "Inflation Targeting in the World Economy," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 346.
  12. Peter Stella, 2002. "Central Bank Financial Strength, Transparency, and Policy Credibility," IMF Working Papers 02/137, International Monetary Fund.
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