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

Listed author(s):
  • 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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  1. Bennett T. McCallum, 2001. "Inflation Targeting and the Liquidity Trap," Working Papers Central Bank of Chile 112, Central Bank of Chile.
  2. Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 2000. "Avoiding Liquidity Traps," Departmental Working Papers 199925, Rutgers University, Department of Economics.
  3. Lars E. O. Svensson, 2003. "Monetary Policy and Real Stabilization," NBER Working Papers 9486, National Bureau of Economic Research, Inc.
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  5. Obstfeld, Maurice & Rogoff, Kenneth, 2001. "Global Implications of Self-Orientated National Monetary Rules," CEPR Discussion Papers 2856, C.E.P.R. Discussion Papers.
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