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How to Fight Deflation in a Liquidity Trap

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Author Info

  • Gauti B. Eggertsson

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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Bibliographic Info

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

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Length: 42
Date of creation: 01 Mar 2003
Date of revision:
Handle: RePEc:imf:imfwpa:03/64

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Related research

Keywords: Stock markets; Interest rates; Money; Economic models; inflation; money supply; monetary policy; central bank; nominal interest rate; price level; inflation target; aggregate demand; open market operations; foreign exchange; money balances; real money; nominal interest rates; monetary base; printing money; real value; monetary economics; independent central bank; price stability; quantity theory of money; money demand; inflation rate; real rate of interest; real interest rates; independent ? central bank; open market operation; theory of money; rational expectations; monetary fund; optimal monetary policy; monetary authorities; quantity theory; monetary system; low inflation; discount rate; rate of inflation; stock market crash; monetary expansion; monetary stabilization; monetary policy rules; monetary policies; monetary authority; high inflation; monetary systems;

References

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  1. Woodford, Michael, 2001. "Fiscal Requirements for Price Stability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(3), pages 669-728, August.
  2. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  3. David Reifschneider & John C. Williams, 1999. "Three lessons for monetary policy in a low inflation era," Finance and Economics Discussion Series 1999-44, Board of Governors of the Federal Reserve System (U.S.).
  4. Svensson, Lars, 1999. "How Should Monetary Policy Be Conducted in an Era of Price Stability," Seminar Papers 680, Stockholm University, Institute for International Economic Studies.
  5. 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.
  6. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
  7. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
  8. Summers, Lawrence, 1991. "How Should Long-Term Monetary Policy Be Determined? Panel Discussion," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 625-31, August.
  9. 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.).
  10. 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.
  11. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
  12. 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.
  13. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  14. McCallum, Bennett T, 2000. "Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(4), pages 870-904, November.
  15. Obstfeld, Maurice, 1997. "Dynamic Seigniorage Theory," Macroeconomic Dynamics, Cambridge University Press, vol. 1(03), pages 588-614, September.
  16. Robert E. Lucas Jr. & Nancy L. Stokey, 1982. "Optimal Fiscal and Monetary Policy in an Economy Without Capital," Discussion Papers 532, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  17. Michael Woodford, 1999. "Commentary : how should monetary policy be conducted in an era of price stability?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 277-316.
  18. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  19. 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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  1. Return of Undergraduate Macro?
    by CV in Alpha.Sources.CV on 2013-10-07 08:07:13
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