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A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap

In: Monetary Policy with Very Low Inflation in the Pacific Rim, NBER-EASE, Volume 15

  • Bennett T. McCallum

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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This chapter was published in:
  • Takatoshi Ito & Andrew K. Rose, 2006. "Monetary Policy with Very Low Inflation in the Pacific Rim, NBER-EASE, Volume 15," NBER Books, National Bureau of Economic Research, Inc, number ito_06-1, October.
  • This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 0088.
    Handle: RePEc:nbr:nberch:0088
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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    7. Frank Smets & Raf Wouters, 2002. "Openness, imperfect exchange rate pass-through and monetary policy," Working Paper Research 19, National Bank of Belgium.
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