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Liquidity traps: how to avoid them and how to escape them

  • Willem H Buiter
  • Nikolaos Panigirtzoglou

An economy is in a liquidity trap when monetary policy cannot influence either real or nominal variables of interest. A necessary condition for this is that the short nominal interest rate is constrained by its lower bound, typically zero. The paper develops a small analytical model to show how an economy can get into a liquidity trap, how it can avoid getting into one and how it can get out. The empirical likelihood of the UK economy hitting the zero nominal rate bound is considered by investigating the relationship between the level of the short nominal interest rate and its volatility. The empirical evidence on this issue is mixed. To reduce the risk of falling into a liquidity trap, the authorities have two options. The first is to raise the inflation target. 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 - ie 'taxing money', as advocated by Gesell. Once in a liquidity trap, there are two means of escape. The first is to use expansionary fiscal policy. The second is, again, to lower the zero nominal interest rate floor. There are likely to be significant shoe leather costs associated with any scheme to tax currency.

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Paper provided by Bank of England in its series Bank of England working papers with number 111.

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Date of creation: Apr 2000
Date of revision:
Handle: RePEc:boe:boeewp:111
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  1. James A. Clouse & Dale W. Henderson & Athanasios Orphanides & David H. Small & Peter A. Tinsley, 2000. "Monetary policy when the nominal short-term interest rate is zero," Finance and Economics Discussion Series 2000-51, Board of Governors of the Federal Reserve System (U.S.).
  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, vol. 4(1), pages 1-25, February.
  3. 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.
  4. Jag Chadha & Andrew Haldane & Norbert Janssen, 1998. "Shoe-leather costs reconsidered," Bank of England working papers 86, Bank of England.
  5. Karen H. Johnson & David H. Small & Ralph W. Tryon, 1999. "Monetary policy and price stability," International Finance Discussion Papers 641, Board of Governors of the Federal Reserve System (U.S.).
  6. James Tobin, 1956. "Liquidity Preference as Behavior Towards Risk," Cowles Foundation Discussion Papers 14, Cowles Foundation for Research in Economics, Yale University.
  7. 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.
  8. 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.
  9. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, vol. 47(3), pages 1209-27, July.
  10. 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.
  11. 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, vol. 15(1), pages 57-85, January.
  12. 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.
  13. 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.
  14. Buiter, Willem H., 1977. "`Crowding out' and the effectiveness of fiscal policy," Journal of Public Economics, Elsevier, vol. 7(3), pages 309-328, June.
  15. 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.
  16. Christina D. Romer & David H. Romer, 1997. "Reducing Inflation: Motivation and Strategy," NBER Books, National Bureau of Economic Research, Inc, number rome97-1, December.
  17. Tödter, Karl-Heinz & Ziebarth, Gerhard, 1997. "Price stability versus low inflation in Germany: An analysis of costs and benefits," Discussion Paper Series 1: Economic Studies 1997,03e, Deutsche Bundesbank, Research Centre.
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