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The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

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  • Svensson, Lars

    ()
    (Institute for International Economic Studies, Stockholm University)

Abstract

The paper examines the transmission mechanism of monetary policy in an open economy with and without a binding zero bound on nominal interest rates. In particular, a foolproof way of escaping from a liquidity trap is suggested, consisting of a price-level target path, a devaluation of the currency and an exchange-rate peg, which is later abandoned in favor of price-level or inflation targeting when the price-level target is reached. This will jump-start the economy by a real depreciation of the domestic currency, a lower long real interest rate, and increased inflation expectations. The abandonment of the exchange-rate peg and shift to price-level or inflation targeting will avoid the risk of overheating. Some conclusions for Japan are also included.

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Bibliographic Info

Paper provided by Stockholm University, Institute for International Economic Studies in its series Seminar Papers with number 687.

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Length: 53 pages
Date of creation: 03 Aug 2000
Date of revision:
Handle: RePEc:hhs:iiessp:0687

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Postal: Institute for International Economic Studies, Stockholm University, S-106 91 Stockholm, Sweden
Phone: +46-8-162000
Fax: +46-8-161443
Web page: http://www.iies.su.se/
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Keywords: Deflation; liquidity trap; nominal interest rates.;

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References

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  1. Mervyn King, 1999. "Challenges for monetary policy : new and old," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 11-57.
  2. Smets, Frank, 2000. "What horizon for price stability," Working Paper Series 0024, European Central Bank.
  3. Hallman, Jeffrey J & Porter, Richard D & Small, David H, 1991. "Is the Price Level Tied to the M2 Monetary Aggregate in the Long Run?," American Economic Review, American Economic Association, vol. 81(4), pages 841-58, September.
  4. David E. Lebow, 1993. "Monetary policy at near-zero interest rates," Working Paper Series / Economic Activity Section 136, Board of Governors of the Federal Reserve System (U.S.).
  5. Arturo Extrella & Jeffrey C. Fuhrer, 1998. "Dynamic inconsistencies: counterfactual implications of a class of rational expectations models," Working Papers 98-5, Federal Reserve Bank of Boston.
  6. Willem H Buiter & Nikolaos Panigirtzoglou, 2000. "Liquidity traps: how to avoid them and how to escape them," Bank of England working papers 111, Bank of England.
  7. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August.
  8. Uhlig, Harald, 2000. "Should We be Afraid of Friedman's Rule?," CEPR Discussion Papers 2548, C.E.P.R. Discussion Papers.
  9. Robert L. Hetzel, 1999. "Japanese monetary policy: a quantity theory perspective," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 1-26.
  10. Gerlach, Stefan & Svensson, Lars E O, 2002. "Money and Inflation in the Euro-Area: A Case for Monetary Indicators?," CEPR Discussion Papers 3392, C.E.P.R. Discussion Papers.
  11. Clouse James & Henderson Dale & Orphanides Athanasios & Small David H. & Tinsley P.A., 2003. "Monetary Policy When the Nominal Short-Term Interest Rate is Zero," The B.E. Journal of Macroeconomics, De Gruyter, vol. 3(1), pages 1-65, September.
  12. Leitemo,K., 1999. "Inflation targeting strategies in small open economies," Memorandum 21/1999, Oslo University, Department of Economics.
  13. Fuhrer, Jeffrey C & Moore, George R, 1995. "Monetary Policy Trade-offs and the Correlation between Nominal Interest Rates and Real Output," American Economic Review, American Economic Association, vol. 85(1), pages 219-39, March.
  14. Goodfriend, Marvin, 2000. "Overcoming the Zero Bound on Interest Rate Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(4), pages 1007-35, November.
  15. Karen Johnson & David Small & Ralph Tryon, 1999. "Monetary policy and price stability," International Finance Discussion Papers 641, Board of Governors of the Federal Reserve System (U.S.).
  16. 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.
  17. Jordi Gali & Tommaso Monacelli, 1999. "Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Boston College Working Papers in Economics 438, Boston College Department of Economics, revised 15 Nov 1999.
  18. David O. Cushman & Tao Zha, 1995. "Identifying monetary policy in a small open economy under flexible exchange rates," Working Paper 95-7, Federal Reserve Bank of Atlanta.
  19. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
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  1. Larry Elliott on HM Treasury and NGDP Targeting
    by Britmouse in uneconomical on 2012-08-28 21:16:39
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