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Monetary and Fiscal Policy to Escape from a Deflationary Trap

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Author Info
Iwamoto, Yasushi (Hitotsubashi U)

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Abstract

This paper provides a theoretical overview of monetary and fiscal policy with the potential to engineer an exit from a deflationary trap, which we define here as sustained deflation in the presence of zero interest rates. We find that the required policy steps are an interest rate hike, a commitment to future currency growth, and a money-financed tax cut. The amount of tax cut required is equal to the increase in the central bank's payments to the treasury resulting from the higher inflation rate (nominal interest rate), while fiscal policymakers must maintain fiscal discipline by stabilizing government debt and the primary balance. There will be a temporary fall in output when prices are sticky , but this is the price that must be paid to conquer deflation. The current commitment to quantitative easing is based on the assumption that the natural interest rate has temporarily declined. If the economy is in a deflationary trap, however, the continuation of zero interest rates reinforces deflationary expectations and may make it perpetually impossible to eliminate deflation. Even under conditions in which the natural rate of interest seems to be positive, if deflation persists, it is probably wise to consider a policy approach that assumes deflationary trap conditions. With this in mind, we believe the conditions required for abandoning the current policy regime should include, in addition to consistently positive growth in the consumer price index (CPI), a consideration of the trend in real GDP.

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Article provided by Institute for Monetary and Economic Studies, Bank of Japan in its journal Monetary and Economic Studies.

Volume (Year): 23 (2005)
Issue (Month): 1 (February)
Pages: 1-46
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Handle: RePEc:ime:imemes:v:23:y:2005:i:1:p:1-46

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Find related papers by JEL classification:
E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation

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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Tom Cargill & Federico Guerrero, 2006. "A Reassessment of the Problems with Interest Targeting: What Have We Learned from Japanese Monetary Policy?," Working Papers 06-010, University of Nevada, Reno, Department of Economics & University of Nevada, Reno , Department of Resource Economics. [Downloadable!]
  2. Keynote Speech by Bennett T. McCallum, 2006. "Misconceptions Regarding the Zero Lower Bound on Interest Rates," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 24(S1), pages 13-26, December. [Downloadable!]
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