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Liquidity Traps: How to Avoid Them and How to Escape Them

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  • Willem H. Buiter
  • Nikolaos Panigirtzoglou

Abstract

The paper considers ways of avoiding a liquidity trap and ways of getting out of one. Unless lower short nominal interest rates are associated with significantly lower interest volatility, a lower average rate of inflation, which will be associated with lower expected nominal interest rates, increases the odds that the zero nominal interest rate floor will become a binding constraint. The empirical evidence on this issue is mixed. Once in a liquidity trap, there are two means of escape. The first is to use expansionary fiscal policy. The second is to lower the zero nominal interest rate floor. This second option involves paying negative interest on government 'bearer bonds' -- coin and currency, that is 'taxing money', as advocated by Gesell. This would also reduce the likelihood of ending up in a liquidity trap. Taxing currency amounts to having periodic 'currency reforms', that is, compulsory conversions of 'old' currency into 'new' currency, say by stamping currency. The terms of the conversion can be set to achieve any positive or negative interest rate on currency. There are likely to be significant shoe leather costs associated with such schemes. The policy question then becomes how much shoe leather it takes to fill an output gap? Finally the paper develops a simple analytical model showing how the economy can get into a liquidity trap and how Gesell money is one way of avoiding it or escaping from it.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7245.

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Date of creation: Jul 1999
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Publication status: published as Reflections on Economics and Econometrics, Essays in Honour of Martin Fase, edited by Wim F.V. Vanthoor and Joke Mooij, 2001, pp. 13-58, De Nederlandsche Bank NV, Amsterdam.
Handle: RePEc:nbr:nberwo:7245

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  1. Willem H. Buiter & Nikolaos Panigirtzoglou, 1999. "Liquidity Traps: How to Avoid Them and How to Escape Them," NBER Working Papers 7245, National Bureau of Economic Research, Inc.
  2. Coenen Günter & Orphanides Athanasios & Wieland Volker, 2004. "Price Stability and Monetary Policy Effectiveness when Nominal Interest Rates are Bounded at Zero," The B.E. Journal of Macroeconomics, De Gruyter, De Gruyter, vol. 4(1), pages 1-25, February.
  3. George A. Akerlof & William R. Dickens & George L. Perry, 1996. "The Macroeconomics of Low Inflation," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(1), pages 1-76.
  4. Christina D. Romer & David H. Romer, 1997. "Reducing Inflation: Motivation and Strategy," NBER Books, National Bureau of Economic Research, Inc, number rome97-1, July.
  5. Martin S. Feldstein, 1997. "The Costs and Benefits of Going from Low Inflation to Price Stability," NBER Chapters, in: Reducing Inflation: Motivation and Strategy, pages 123-166 National Bureau of Economic Research, Inc.
  6. Buiter, Willem H., 1977. "`Crowding out' and the effectiveness of fiscal policy," Journal of Public Economics, Elsevier, Elsevier, vol. 7(3), pages 309-328, June.
  7. 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, Board of Governors of the Federal Reserve System (U.S.) 2000-51, Board of Governors of the Federal Reserve System (U.S.).
  8. Taylor, John B., 1981. "On the relation between the variability of inflation and the average inflation rate," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 15(1), pages 57-85, January.
  9. Karl-Heinz Todter & Gerhard Ziebarth, 1997. "Price Stability vs. Low Inflation in Germany: An Analysis of Costs and Benefits," NBER Working Papers 6170, National Bureau of Economic Research, Inc.
  10. Laurence Ball & Stephen G. Cecchetti, 1990. "Inflation and Uncertainty at Long and Short Horizons," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 21(1), pages 215-254.
  11. Jag Chadha & Andrew Haldane & Norbert Janssen, 1998. "Shoe-leather costs reconsidered," Bank of England working papers, Bank of England 86, Bank of England.
  12. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, American Finance Association, vol. 47(3), pages 1209-27, July.
  13. James Tobin, 1956. "Liquidity Preference as Behavior Towards Risk," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 14, Cowles Foundation for Research in Economics, Yale University.
  14. Arthur M. Okun, 1975. "Inflation: Its Mechanics and Welfare Costs," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 6(2), pages 351-402.
  15. Karen Johnson & David Small & Ralph Tryon, 1999. "Monetary policy and price stability," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 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.
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