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The Case for Open-Market Purchases in a Liquidity Trap

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Author Info
Alan Auerbach (Department of Economics, University of California Berkeley)
Maurice Obstfeld (University of California, Berkeley and CEPR and NBER)

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Abstract

Prevalent thinking about liquidity traps suggests that the perfect substitutability of money and bonds at a zero short-term nominal interest rate renders open-market operations ineffective for achieving macroeconomic stabilization goals. We show that even were this the case, there remains a powerful argument for large-scale open market operations as a fiscal policy tool. As we also demonstrate, however, this same reasoning implies that open-market operations will be beneficial for stabilization as well, even when the economy is expected to remain mired in a liquidity trap for some time. Thus, the microeconomic fiscal benefits of open-market operations in a liquidity trap go hand in hand with standard macroeconomic objectives. Motivated by Japan's recent economic experience, we use a dynamic general-equilibrium model to assess the welfare impact of open-market operations for an economy in Japan's predicament. We argue Japan can achieve a substantial welfare improvement through large open-market purchases of domestic government debt.

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Paper provided by Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley in its series Center for International and Development Economics Research, Working Paper Series with number 1051.

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Date of creation: 03 May 2004
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Handle: RePEc:cdl:ciders:1051

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Keywords: liquidity trap; zero bound; Japan;

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  6. 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(1998-2), pages 137-206. [Downloadable!]
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  11. Calvo, Guillermo A, 1978. "On the Time Consistency of Optimal Policy in a Monetary Economy," Econometrica, Econometric Society, vol. 46(6), pages 1411-28, November. [Downloadable!] (restricted)
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  21. Svensson, Lars E O, 2000. "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap," CEPR Discussion Papers 2566, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  22. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Optimal Fiscal and Monetary Policy Under Sticky Prices," NBER Working Papers 9220, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  23. Rishi Goyal & Ronald McKinnon, 2003. "Japan's Negative Risk Premium in Interest Rates: The Liquidity Trap and the Fall in Bank Lending," The World Economy, Blackwell Publishing, vol. 26(3), pages 339-363, 03. [Downloadable!] (restricted)
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