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How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible

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Author Info
Gauti B. Eggertsson

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Abstract

I model deflation, at zero nominal interest rate, in a microfounded general equilibrium model. I show that deflation can be analyzed as a credibility problem if the government has only one policy instrument, money supply carried out by means of open market operations in short-term bonds, and cannot commit to future policies. I propose several policies to solve the credibility problem. They involve printing money or nominal debt and either (1) cutting taxes, (2) buying real assets such as stocks, or (3) purchasing foreign exchange. The government credibly "commits to being irresponsible" by using these policy instruments. It commits to higher money supply in the future so that the private sector expects inflation instead of deflation. This is optimal, since it curbs deflation and increases output by lowering the real rate of return.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 03/64.

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Length: 41 pages
Date of creation: 16 Apr 2003
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Handle: RePEc:imf:imfwpa:03/64

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Related research
Keywords: Deflation ; Liquidity ; Stock markets ; Interest rates ; Money ; Economic models ;

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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.:
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    Other versions:
  2. Andrew Levin, 1990. "Monetary Stabilization Policy in a General Equilibrium Model with Wage Contracts," University of California at San Diego, Economics Working Paper Series 90-43, Department of Economics, UC San Diego.
  3. Michael Woodford, 1999. "Commentary : how should monetary policy be conducted in an era of price stability?," Proceedings, Federal Reserve Bank of Kansas City, pages 277-316. [Downloadable!]
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  5. Woodford, Michael, 2001. "Fiscal Requirements for Price Stability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(3), pages 669-728, August.
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  6. Reifschneider, David & Willams, John C, 2000. "Three Lessons for Monetary Policy in a Low-Inflation Era," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(4), pages 936-66, November.
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  9. 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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  10. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February. [Downloadable!] (restricted)
  11. Lars E.O. Svensson, 1999. "How should monetary policy be conducted in an era of price stability?," Proceedings, Federal Reserve Bank of Kansas City, pages 195-259. [Downloadable!]
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  12. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall. [Downloadable!]
  13. repec:bep:mactop:v:3:y:2003:i:1:p:1088-1088 is not listed on IDEAS
  14. Obstfeld, Maurice, 1997. "Dynamic Seigniorage Theory," Macroeconomic Dynamics, Cambridge University Press, vol. 1(03), pages 588-614, September. [Downloadable!]
  15. Wolman, Alexander L, 2005. "Real Implications of the Zero Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 37(2), pages 273-96, April.
    Other versions:
  16. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June. [Downloadable!] (restricted)
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  19. 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. [Downloadable!] (restricted)
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Cited by:
(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. Cees Ullersma & Gerben Hieminga, 2006. "Note on zero lower bound worries," DNB Working Papers 117, Netherlands Central Bank, Research Department. [Downloadable!]
  2. 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:
  3. Olivier Jeanne & Lars E. O. Svensson, 2007. "Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank," American Economic Review, American Economic Association, vol. 97(1), pages 474-490, March. [Downloadable!]
    Other versions:
  4. Eric Le Borgne & Gauti B. Eggertsson, 2007. "Dynamic Incentives and the Optimal Delegation of Political Power," IMF Working Papers 07/91, International Monetary Fund. [Downloadable!]
  5. Buiter, Willem H, 2004. "Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap," CEPR Discussion Papers 4202, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  6. Alan J. Auerbach & Maurice Obstfeld, 2003. "The Case for Open-Market Purchases in a Liquidity Trap," NBER Working Papers 9814, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  7. 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. [Downloadable!]
    Other versions:
  8. Kuttner, Kenneth-N, 2004. "Comments on "Price Stability and Japanese Monetary Policy."," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 22(3), pages 37-46, October. [Downloadable!]
  9. Frederic S. Mishkin, 2005. "The Fed after Greenspan," Eastern Economic Journal, Eastern Economic Association, vol. 31(3), pages 317-332, Summer. [Downloadable!]
  10. Fernando M. Gonçalves, 2008. "Accumulating Foreign Reserves Under Floating Exchange Rates," IMF Working Papers 08/96, International Monetary Fund. [Downloadable!]
  11. Mark R. Stone, 2003. "Greater Monetary Policy Transparency for the G3: Lessons from Full-Fledged Inflation Targeters," IMF Working Papers 03/218, International Monetary Fund. [Downloadable!]
  12. Iwamoto, Yasushi, 2005. "Monetary and Fiscal Policy to Escape from a Deflationary Trap," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 23(1), pages 1-46, February. [Downloadable!]
  13. Charles Frederick Kramer & Mark R. Stone, 2005. "A Post-Reflation Monetary Framework for Japan," IMF Working Papers 05/73, International Monetary Fund. [Downloadable!]
  14. 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)
  15. Junning Cai, 2004. "Liquidity Trap Prevention and Escape: A Simple Proposition," Macroeconomics 0402033, EconWPA. [Downloadable!]
  16. Gauti Eggertsson & Eric Le Borgne, 2005. "The politics of central bank independence: a theory of pandering and learning in government," Staff Reports 205, Federal Reserve Bank of New York. [Downloadable!]
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