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A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap

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  • Bennett T. McCallum

Abstract

In analyses of "liquidity trap" problems associated with the zero lower bound (ZLB) on nominal interest rates, it is important to emphasize the difference between policy rule changes, intended to help escape an existing ZLB situation, and maintained policy rules designed so as to avoid ZLB situations. Analysis assuming that rule changes would lead to a new RE equilibrium immediately seems implausible. Accordingly, the paper focuses on the design of a rule that should retain stabilization effectiveness even if the economy is temporarily shocked into a ZLB situation. The rule considered is one that uses as its instrument variable a weighted average of an interest rate and the rate of depreciation of the nominal exchange rate. With a small weight attached to the depreciation term, it will be nearly irrelevant in normal situations but call for strong adjustments when the ZLB condition prevails. Stabilizing properties of this "MC" rule are studied within a small open economy model developed by McCallum and Nelson. Results indicate that under ZLB conditions the MC rule will provide strong stabilizing policy actions yet, under conditions such that the ZLB constraint is not relevant, the MC rule need not hinder monetary policy.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11056.

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Date of creation: Jan 2005
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Publication status: published as A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap , Bennett T. McCallum . in Monetary Policy with Very Low Inflation in the Pacific Rim, NBER-EASE, Volume 15 , Ito and Rose. 2006
Handle: RePEc:nbr:nberwo:11056

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  1. Laurence Ball, 1998. "Policy Rules for Open Economies," RBA Research Discussion Papers, Reserve Bank of Australia rdp9806, Reserve Bank of Australia.
  2. Coenen, Günter & Wieland, Volker, 2003. "The Zero-Interest Rate Bound and the Role of the Exchange Rate for Monetary Policy in Japan," CEPR Discussion Papers, C.E.P.R. Discussion Papers 3895, C.E.P.R. Discussion Papers.
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Cited by:
  1. Bennett T. McCallum, 2007. "Monetary Policy in East Asia: the Case of Singapore," IMES Discussion Paper Series 07-E-010, Institute for Monetary and Economic Studies, Bank of Japan.
  2. Sebastian Edwards, 2006. "External Imbalances in an Advanced, Commodity-Exporting Country: The Case of New Zealand," NBER Working Papers 12620, National Bureau of Economic Research, Inc.
  3. Vitor Gaspar & Frank Smets & David Vestin, 2006. "Optimal Monetary Policy under Adaptive Learning," Computing in Economics and Finance 2006, Society for Computational Economics 183, Society for Computational Economics.
  4. Hagedorn, Marcus, 2008. "Nominal and real interest rates during an optimal disinflation in New Keynesian models," Working Paper Series, European Central Bank 0878, European Central Bank.
  5. Jacek Krawczyk & Rishab Sethi, 2007. "Satisficing Solutions for New Zealand Monetary Policy," Reserve Bank of New Zealand Discussion Paper Series DP2007/03, Reserve Bank of New Zealand.
  6. Teo, Wing Leong, 2009. "Can exchange rate rules be better than interest rate rules?," Japan and the World Economy, Elsevier, Elsevier, vol. 21(3), pages 301-311, August.

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