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Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others

  • Lars E.O. Svensson

Existing proposals to escape from a liquidity trap and deflation, including my "Foolproof Way," are discussed in the light of the optimal way to escape. The optimal way involves three elements: (1) an explicit central-bank commitment to a higher future price level; (2) a concrete action that demonstrates the central bank's commitment, induces expectations of a higher future price level and jump-starts the economy; and (3) an exit strategy that specifies when and how to get back to normal. A currency depreciation is a direct consequence of expectations of a higher future price level and hence an excellent indicator of those expectations. Furthermore, an intentional currency depreciation and a crawling peg, as in the Foolproof Way, can implement the optimal way and, in particular, induce the desired expectations of a higher future price level. I conclude that the Foolproof Way is likely to work well for Japan, which is in a liquidity trap now, as well as for the euro area and the United States, in case either would fall into a liquidity trap in the future.

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/089533003772034934
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Article provided by American Economic Association in its journal Journal of Economic Perspectives.

Volume (Year): 17 (2003)
Issue (Month): 4 (Fall)
Pages: 145-166

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Handle: RePEc:aea:jecper:v:17:y:2003:i:4:p:145-166
Note: DOI: 10.1257/089533003772034934
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