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The Liquidity Trap in an Open Economy

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  • Buiter, Willem H

Abstract

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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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2923.

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Date of creation: Aug 2001
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Handle: RePEc:cpr:ceprdp:2923

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Related research

Keywords: Gesell; international capital mobility; Liquidity trap; taxing money;

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References

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  1. Lars E.O. Svensson, 2000. "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap," NBER Working Papers 7957, National Bureau of Economic Research, Inc.
  2. Coenen, Günter & Orphanides, Athanasios & Wieland, Volker, 2003. "Price Stability and Monetary Policy Effectiveness when Nominal Interest Rates are Bounded at Zero," CEPR Discussion Papers 3892, C.E.P.R. Discussion Papers.
  3. Willem H. Buiter & Nikolaos Panigirtzoglou, 1999. "Liquidity Traps: How to Avoid Them and How to Escape Them," NBER Working Papers 7245, National Bureau of Economic Research, Inc.
  4. Benhabib, Jess & Schmitt-Grohé, Stephanie & Uribe, Martín, 1999. "The Perils of Taylor Rules," CEPR Discussion Papers 2314, C.E.P.R. Discussion Papers.
  5. Jeffrey Fuhrer & Brian Madigan, 1994. "Monetary policy when interest rates are bounded at zero," Working Papers 94-1, Federal Reserve Bank of Boston.
  6. Bennett T. McCallum, 2000. "Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates," NBER Working Papers 7677, National Bureau of Economic Research, Inc.
  7. James Clouse & Dale Henderson & Athanasios Orphanides & David Small & Peter Tinsley, 2000. "Monetary policy when the nominal short-term interest rate is zero," Finance and Economics Discussion Series 2000-51, Board of Governors of the Federal Reserve System (U.S.).
  8. Bennett McCallum, 2001. "Inflation targeting and the liquidity trap," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  9. 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.
  10. Bennett T. McCallum, 2001. "Inflation Targeting and the Liquidity Trap," NBER Working Papers 8225, National Bureau of Economic Research, Inc.
  11. Alexander L. Wolman, 1998. "Staggered price setting and the zero bound on nominal interest rates," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 1-24.
  12. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  13. Hondroyiannis, George & Swamy, P. A. V. B. & Tavlas, George S., 2000. "Is the Japanese economy in a liquidity trap?," Economics Letters, Elsevier, vol. 66(1), pages 17-23, January.
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Citations

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Cited by:
  1. Coenen, Guenter & Wieland, Volker, 2003. "The Zero-Interest-Rate and the Role of the Exchange Rate for Monetary Policy in Japan," CFS Working Paper Series 2003/09, Center for Financial Studies (CFS).
  2. Volker Wieland (Goethe University Frankfurt) & Günter Coenen (European Central Bank), 2004. "Exchange Rate Policy and the Zero Bound on Nominal Interest Rates," Computing in Economics and Finance 2004 65, Society for Computational Economics.
  3. Coenen, Gunter & Wieland, Volker, 2003. "The zero-interest-rate bound and the role of the exchange rate for monetary policy in Japan," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 1071-1101, July.

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