The Paper studies the implications of the zero lower bound on the short nominal rate of interest for the conduct of monetary policy in a small open economy with a floating exchange rate and perfect international capital mobility. Monetary policy affects aggregate demand through the real exchange rate. When monetary policy follows a simplified Taylor rule for the short nominal interest rate, there exists a unique solution orbit that leads to the normal steady state. For any initial inflation rate below the target inflation rate (the normal steady-state rate of inflation under the Taylor rule), there also exists a continuum of other solution orbits that do not converge to the normal steady state but instead circle the liquidity trap steady state. Along these solution orbits, periods of rising inflation and excess demand alternate with periods of falling inflation and excess capacity. For some solution orbits, nominal interest rates are at the zero lower bound for all maturities – the pure liquidity trap case. For others, nominal interest rates beyond a certain maturity will be positive. By adopting a rule for the short nominal interest rate on currency that systematically keeps it below the short nominal interest rate on non-monetary securities, the lower bound on the short nominal interest rate on non-monetary securities is eliminated and the liquidity trap disappears. This rule may involve paying negative interest on currency, or taxing currency. Proposals for taxing currency go back at least to Gesell. They inevitably involve non-trivial problems of administration and enforcement.
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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number
2923.
Find related papers by JEL classification: E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System 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 F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
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Benhabib, J. & Schmitt-Grohe, S. & Uribe, M., 1999.
"Avoiding Liquidity Traps,"
Working Papers
99-21, C.V. Starr Center for Applied Economics, New York University.
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Other versions:
Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 2002.
"Avoiding Liquidity Traps,"
Journal of Political Economy,
University of Chicago Press, vol. 110(3), pages 535-563, June.
[Downloadable!] (restricted)
Benhabib, Jess & Schmitt-Grohé, Stephanie & Uribe, Martín, 1999.
"The Perils of Taylor Rules,"
CEPR Discussion Papers
2314, C.E.P.R. Discussion Papers.
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Other versions:
Benhabib, Jess & Schmitt-Grohe, Stephanie & Uribe, Martin, 1998.
"The Perils of Taylor Rules,"
Working Papers
98-37, C.V. Starr Center for Applied Economics, New York University.
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