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The Case for Open-Market Purchases in a Liquidity Trap

  • Auerbach, Alan J.
  • Obstfeld, Maurice

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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Paper provided by Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley in its series Center for International and Development Economics Research, Working Paper Series with number qt84s7d8c8.

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Date of creation: 23 Jan 2012
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Handle: RePEc:cdl:ciders:qt84s7d8c8
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  19. Stein, Jeremy C, 1989. "Cheap Talk and the Fed: A Theory of Imprecise Policy Announcements," American Economic Review, American Economic Association, vol. 79(1), pages 32-42, March.
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