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The Magic of the Exchange Rate: Optimal Escape from a Liquidity Trap in Small and Large OPen Economies

Author

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  • Lars E.O. Svensson

    (Princeton University, CEPR and NBER)

Abstract

The optimal escape from a liquidity trap involves generating private-sector expectations of a higher future price level and higher future inflation. This lowers the real interest rate and reduces the recession during the liquidity trap. The problem, emphasized by Krugman, is that central-bank promises of a higher future price level may not be credible. The current exchange rate will be a good indicator of private-sector expectations of the future price level. An intentional currency depreciation (which is technically feasible) will create private-sector expectations of a future weaker currency and a higher future price level. An intentional currency depreciation and a crawling peg (as in the Foolproof Way) can implement the optimal escape from a liquidity trap and make this credible. Optimal escape from a liquidity trap in a large economy does not prevent the rest of the world from achieving its monetary-policy objectives, if the rest of the world is not in a liquidity trap. For negative international output externalities (which may not be very realistic, since they rely on optimal international risk sharing), the rest of the world may fall into a liquidity trap. This nevertheless moves the world equilibrium towards the equilibrium corresponding to optimal international cooperation. For positive international output externalities, any initial liquidity trap in the rest of the world is alleviated or eliminated.

Suggested Citation

  • Lars E.O. Svensson, 2004. "The Magic of the Exchange Rate: Optimal Escape from a Liquidity Trap in Small and Large OPen Economies," Working Papers 072004, Hong Kong Institute for Monetary Research.
  • Handle: RePEc:hkm:wpaper:072004
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. 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.
    2. Ben S. Bernanke & Vincent R. Reinhart & Brian P. Sack, 2004. "Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 35(2), pages 1-100.
    3. Lars E. O. Svensson, 2005. "Targeting versus instrument rules for monetary policy: what is wrong with McCallum and Nelson?," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 613-626.
    4. Martin Bodenstein & Christopher J. Erceg & Luca Guerrieri, 2017. "The effects of foreign shocks when interest rates are at zero," Canadian Journal of Economics, Canadian Economics Association, vol. 50(3), pages 660-684, August.
    5. Pavasuthipaisit, Robert, 2007. "Optimal exchange rate policy in a low interest rate environment," MPRA Paper 3596, University Library of Munich, Germany.
    6. Pavasuthipaisit, Robert, 2009. "Optimal exchange-rate policy in a low interest rate environment," Journal of the Japanese and International Economies, Elsevier, vol. 23(3), pages 264-282, September.
    7. Nakajima, Tomoyuki, 2008. "Liquidity trap and optimal monetary policy in open economies," Journal of the Japanese and International Economies, Elsevier, vol. 22(1), pages 1-33, March.

    More about this item

    Keywords

    Zero bound; deflation; foolproof way; international policy coordination; noncooperation and cooperation;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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