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

  • Lars E.O. Svensson

    (Princeton University, CEPR and NBER)

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.

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Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 072004.

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Length: 56 pages
Date of creation: Apr 2004
Date of revision:
Handle: RePEc:hkm:wpaper:072004
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  1. V. V Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Oxford University Press, vol. 69(3), pages 533-563.
  2. Benhabib, Jess & Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Avoiding Liquidity Traps," CEPR Discussion Papers 2948, C.E.P.R. Discussion Papers.
  3. Jordi Galí & Mark Gertler & J. David López-Salido, 2002. "Markups, gaps, and the welfare costs of business fluctuations," Banco de Espa�a Working Papers 0204, Banco de Espa�a.
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  5. Matthew B. Canzoneri & Robert E. Cumby & Behzad T. Diba, 2002. "The Need for International Policy Coordination: What's Old, What's New, What's Yet to Come?," NBER Working Papers 8765, National Bureau of Economic Research, Inc.
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  7. Maurice Obstfeld and Kenneth Rogoff., 2001. "Global Implications of Self-Oriented National Monetary Rules," Center for International and Development Economics Research (CIDER) Working Papers C01-120, University of California at Berkeley.
  8. Lars E.O. Svensson, 2002. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Working Papers 118, Princeton University, Department of Economics, Center for Economic Policy Studies..
  9. Olivier Jeanne & Lars E. O. Svensson, 2007. "Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank," American Economic Review, American Economic Association, vol. 97(1), pages 474-490, March.
  10. Coenen, Guenter & Wieland, Volker, 2003. "The Zero-Interest-Rate and the Role of the Exchange Rate for Monetary Policy in Japan," CFS Working Paper Series 2003/09, Center for Financial Studies (CFS).
  11. Hamid Faruqee & Douglas Laxton & Bart Turtelboom & Peter Isard & Eswar Prasad, 1998. "Multimod Mark III; The Core Dynamic and Steady State Model," IMF Occasional Papers 164, International Monetary Fund.
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  13. Benigno, Gianluca & Benigno, Pierpaolo, 2006. "Designing targeting rules for international monetary policy cooperation," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 473-506, April.
  14. Svensson, L.E.O., 1993. "Term, Inflation and Foreign Exchange Risk Premia: A Unified Treatment," Papers 548, Stockholm - International Economic Studies.
  15. James Clouse & Dale Henderson & Athanasios Orphanides & David Small & Peter 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.).
  16. Marvin Goodfriend, 2000. "Overcoming the zero bound on interest rate policy," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 1007-1057.
  17. Orphanides, Athanasios & Wieland, Volker, 2000. "Efficient Monetary Policy Design near Price Stability," Journal of the Japanese and International Economies, Elsevier, vol. 14(4), pages 327-365, December.
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  19. Lars E.O. Svensson, 2003. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," NBER Working Papers 10195, National Bureau of Economic Research, Inc.
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