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Inflation Targeting and the Liquidity Trap

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  • Bennett T. McCallum

Abstract

This paper considers whether "liquidity trap" issues have important bearing on the desirability of inflation targeting as a strategy for monetary policy. From a theoretical perspective, it has been suggested that "expectation trap" and "indeterminacy" dangers are created by variants of inflation targeting, the latter when forecasts of future inflation enter the policy rule. This paper argues that these alleged dangers are probably not of practical importance. From an empirical perspective, a quantitative open-economy model is developed and the likelihood of encountering a liquidity trap is explored for several policy rules. Also, it is emphasized that, if a liquidity trap immobilizes the usual interest rate instrument, there is still an exchange-rate channel by means of which monetary policy can exert stabilizing effects. The relevant target variable can still be the inflation rate.

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 112.

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Date of creation: Nov 2001
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Handle: RePEc:chb:bcchwp:112

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