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How to escape a liquidity trap with interest rate rules

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Abstract

I give necessary and sufficient conditions for a class of interest rate feedback rules to eliminate self-fulfilling deflations and all other undesired equilibria in a standard New Keynesian economy with a binding zero lower bound. When the interest rate rule is continuous in the state of the economy, keeping interest rates pegged at zero for a long enough initial period and then switching to a Taylor rule that does not obey the Taylor principle is necessary and sufficient to implement the welfare-maximizing equilibrium in a globally determinate (i.e., unique) way. When the interest rate rule is not continuous, the previous condition is still sufficient but no longer necessary. Fiscal policy is passive, so monetary policy anchors expectations on its own. The interest rate rules I consider do not require central banks to undergo any institutional change and do not rely on the neo- Fisherian mechanism of inducing an increase in inflation by first increasing interest rates..

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  • Duarte, Fernando M., 2016. "How to escape a liquidity trap with interest rate rules," Staff Reports 776, Federal Reserve Bank of New York, revised 01 Dec 2016.
  • Handle: RePEc:fip:fednsr:776
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    Cited by:

    1. Adrian, Tobias & Duarte, Fernando M., 2016. "Financial vulnerability and monetary policy," Staff Reports 804, Federal Reserve Bank of New York, revised 01 Sep 2017.
    2. Gerke, Rafael & Hauzenberger, Klemens, 2017. "The Fisher paradox: A primer," Discussion Papers 20/2017, Deutsche Bundesbank.

    More about this item

    Keywords

    zero lower bound (ZLB); liquidity trap; New Keynesian model; indeterminacy; monetary policy; Taylor rule; Taylor principle; interest rate rule; forward guidance;

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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