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The Case for Open-Market Purchases in a Liquidity Trap

  • Alan J. Auerbach
  • Maurice Obstfeld

Prevalent thinking about liquidity traps suggests that the perfect substitutability of money and bonds at a zero short-term nominal interest rate renders open-market operations ineffective for achieving macroeconomic stabilization goals. We show that even were this the case, there remains a powerful argument for large-scale open market operations as a fiscal policy tool. As we also demonstrate, however, this same reasoning implies that open-market operations will be beneficial for stabilization as well, even when the economy is expected to remain mired in a liquidity trap for some time. Thus, the microeconomic fiscal benefits of open-market operations in a liquidity trap go hand in hand with standard macroeconomic objectives. Motivated by Japan's recent economic experience, we use a dynamic general-equilibrium model to assess the welfare impact of open-market operations for an economy in Japan's predicament. We argue Japan can achieve a substantial welfare improvement through large open-market purchases of domestic government debt.

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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 95 (2005)
Issue (Month): 1 (March)
Pages: 110-137

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Handle: RePEc:aea:aecrev:v:95:y:2005:i:1:p:110-137
Note: DOI: 10.1257/0002828053828473
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