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Monetary policy in deflation: the liquidity trap in history and practice

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Athanasios Orphanides

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Abstract

The experience of the U.S. economy during the mid-1930s, when short-term nominal interest rates were continuously close to zero, is sometimes taken as evidence that monetary policy was ineffective and the economy was in a "liquidity trap." Close examination of the historical policy record for the period indicates that the evidence does not support such assertions. The incomplete and erratic recovery from the Great Depression can be traced to a failure to pursue consistently expansionary policy resulting from an incorrect understanding of monetary policy in an environment of very low short-term nominal interest rates. Commonalities with the Japanese experience during the late 1990s and the inadequacy of short-term interest rates as indicators of the stance of monetary policy are discussed, and a robust operating procedure for implementing monetary policy in a low interest rate environment by adjusting the maturity of targeted interest rate instruments is described.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2004-01.

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Date of creation: 2004
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Handle: RePEc:fip:fedgfe:2004-01

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Keywords: Deflation (Finance) - Japan ; Monetary policy - Japan ; Liquidity (Economics) - Japan;

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This paper has been announced in the following NEP Reports: References listed on IDEAS
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. Christina D. Romer, 1991. "What Ended the Great Depression?," NBER Working Papers 3829, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. 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. [Downloadable!] (restricted)
    Other versions:
  3. 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!]
  4. Orphanides, Athanasios & Wieland, Volker, 2000. "Efficient Monetary Policy Design near Price Stability," Journal of the Japanese and International Economies, Elsevier, vol. 14(4), pages 327-365, December. [Downloadable!] (restricted)
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  5. Athanasios Orphanides, 2003. "Historical monetary policy analysis and the Taylor rule," Finance and Economics Discussion Series 2003-36, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  6. Krugman, Paul, 2000. "Thinking About the Liquidity Trap," Journal of the Japanese and International Economies, Elsevier, vol. 14(4), pages 221-237, December. [Downloadable!] (restricted)
  7. David Reifschneider & John C. Williams, 2000. "Three lessons for monetary policy in a low-inflation era," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 936-978.
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  8. Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(2003-1), pages 139-235. [Downloadable!]
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  10. 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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  11. Marvin Goodfriend, 2000. "Overcoming the zero bound on interest rate policy," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 1007-1057.
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  12. Bennett T. McCallum, 2000. "Theoretical analysis regarding a zero lower bound on nominal interest rates," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 870-935.
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  13. Alan Ahearne & Joseph Gagnon & Jane Haltmaier & Steve Kamin ... [et al.]., 2002. "Preventing deflation: lessons from Japan's experience in the 1990s," International Finance Discussion Papers 729, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  15. Athanasios Orphanides & Volker Wieland, 1998. "Price stability and monetary policy effectiveness when nominal interest rates are bounded at zero," Finance and Economics Discussion Series 1998-35, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  16. Alexander L. Wolman, 1999. "Real Implications of the Zero Bound on Nominal Interest Rates," Computing in Economics and Finance 1999 1152, Society for Computational Economics. [Downloadable!]
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  17. 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. [Downloadable!]
  18. Yutaka Yamaguchi, 2002. "Monetary policy in a changing economic environment," Proceedings, Federal Reserve Bank of Kansas City, pages 241-251. [Downloadable!]
  19. 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.). [Downloadable!]
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  20. Kenneth N. Kuttner & Adam S. Posen, 2001. "The Great Recession: Lessons for Macroeconomic Policy from Japan," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 32(2001-2), pages 93-186. [Downloadable!]
Full references

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(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. Adam, Klaus & Billi, Roberto M, 2003. "Optimal Monetary Policy Under Commitment with a Zero Bound on Nominal Interest Rates," CEPR Discussion Papers 4111, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  2. Takeshi Kobayashi & Mark Spiegel & Nobuyoshi Yamori, 2006. "Quantitative easing and Japanese bank equity values," Working Paper Series 2006-19, Federal Reserve Bank of San Francisco. [Downloadable!]
    Other versions:
  3. Lawrence Christiano & Roberto Motto & Massimo Rostagno, 2004. "The great depression and the Friedman-Schwartz hypothesis," Working Paper Series 326, European Central Bank. [Downloadable!]
    Other versions:
  4. Claudio Morana, 2004. "The Japanese Deflation: Has It Had Real Effects? Could It Have Been Avoided?," ICER Working Papers 29-2004, ICER - International Centre for Economic Research. [Downloadable!]
  5. Edward Nelson & Anna J. Schwartz, 2007. "The Impact of Milton Friedman on Modern Monetary Economics: Setting the Record Straight on Paul Krugman's "Who Was Milton Friedman?"," NBER Working Papers 13546, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  6. Roberto M. Billi & George A. Kahn, 2008. "What is the optimal inflation rate?," Economic Review, Federal Reserve Bank of Kansas City, issue Q II, pages 5-28. [Downloadable!]
  7. James Harrigan & Kenneth Kuttner, 2004. "Lost Decade in Translation: Did the US Learn from Japan's Post-Bubble Mistakes?," NBER Working Papers 10938, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  8. André Meier, 2009. "Panacea, Curse, or Nonevent? Unconventional Monetary Policy in the United Kingdom," IMF Working Papers 09/163, International Monetary Fund. [Downloadable!]
  9. Alfonso Palacio-Vera, 2006. "On Lower-bound Traps: A Framework for the Analysis of Monetary Policy in the ÒAgeÓ of Central Banks," Economics Working Paper Archive wp_478, Levy Economics Institute, The. [Downloadable!]
  10. Christina D. Romer & David H. Romer, 2003. "Choosing the Federal Reserve Chair: Lessons from History," NBER Working Papers 10161, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  11. Gauti B. Eggertsson & Benjamin Pugsley, 2007. "The Mistake of 1937: A General Equilibrium Analysis," CFS Working Paper Series 2007/06, Center for Financial Studies. [Downloadable!]
    Other versions:
  12. repec:bep:macadv:v:4:y:2004:i:1:p:1187-1187 is not listed on IDEAS
  13. Roberto M. Billi, 2005. "The Optimal Inflation Buffer with a Zero Bound on Nominal Interest Rates," Computing in Economics and Finance 2005 25, Society for Computational Economics. [Downloadable!]
  14. Ryu-ichiro Murota & Yoshiyasu Ono, 2009. "Zero Nominal Interest Rates, Unemployment, Excess Reserves and Deflation in a Liquidity Trap," ISER Discussion Paper 0748, Institute of Social and Economic Research, Osaka University. [Downloadable!]
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