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The Liquidity Trap in an Open Economy

  • Buiter, Willem H.

The Paper studies the implications of the zero lower bound on the short nominal rate of interest for the conduct of monetary policy in a small open economy with a floating exchange rate and perfect international capital mobility. Monetary policy affects aggregate demand through the real exchange rate. When monetary policy follows a simplified Taylor rule for the short nominal interest rate, there exists a unique solution orbit that leads to the normal steady state. For any initial inflation rate below the target inflation rate (the normal steady-state rate of inflation under the Taylor rule), there also exists a continuum of other solution orbits that do not converge to the normal steady state but instead circle the liquidity trap steady state. Along these solution orbits, periods of rising inflation and excess demand alternate with periods of falling inflation and excess capacity. For some solution orbits, nominal interest rates are at the zero lower bound for all maturities – the pure liquidity trap case. For others, nominal interest rates beyond a certain maturity will be positive. By adopting a rule for the short nominal interest rate on currency that systematically keeps it below the short nominal interest rate on non-monetary securities, the lower bound on the short nominal interest rate on non-monetary securities is eliminated and the liquidity trap disappears. This rule may involve paying negative interest on currency, or taxing currency. Proposals for taxing currency go back at least to Gesell. They inevitably involve non-trivial problems of administration and enforcement.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2923.

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Date of creation: Aug 2001
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Handle: RePEc:cpr:ceprdp:2923
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  1. Benhabib, J. & Schmitt-Grohe, S. & Uribe, M., 1999. "Avoiding Liquidity Traps," Working Papers 99-21, C.V. Starr Center for Applied Economics, New York University.
  2. Svensson, Lars, 2000. "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap," Seminar Papers 687, Stockholm University, Institute for International Economic Studies.
  3. Athanasios Orphanides & Volker W. Wieland, 1998. "Price stability and monetary policy effectiveness when nominal interest rates are bounded at zero," Finance and Economics Discussion Series 1998-35, Board of Governors of the Federal Reserve System (U.S.).
  4. Buiter, Willem H. & Panigirtzoglou, Nikolaos, 1999. "Liquidity Traps: How to Avoid Them and How to Escape Them," CEPR Discussion Papers 2203, C.E.P.R. Discussion Papers.
  5. Bennett T. McCallum, 2001. "Inflation Targeting and the Liquidity Trap," NBER Working Papers 8225, National Bureau of Economic Research, Inc.
  6. Bennett T. McCallum, 2001. "Inflation targeting and the liquidity trap," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  7. Alexander L. Wolman, 1998. "Staggered price setting and the zero bound on nominal interest rates," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 1-24.
  8. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  9. Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 1998. "The perils of Taylor Rules," Departmental Working Papers 199831, Rutgers University, Department of Economics.
  10. 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.).
  11. 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.
  12. Bennett T. McCallum, 2000. "Theoretical analysis regarding a zero lower bound on nominal interest rates," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 870-935.
  13. Jeffrey C. Fuhrer & Brian Madigan, 1994. "Monetary policy when interest rates are bounded at zero," Working Papers 94-1, Federal Reserve Bank of Boston.
  14. Hondroyiannis, George & Swamy, P. A. V. B. & Tavlas, George S., 2000. "Is the Japanese economy in a liquidity trap?," Economics Letters, Elsevier, vol. 66(1), pages 17-23, January.
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