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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. Lars E. O. Svensson, 2003. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Journal of Economic Literature, American Economic Association, vol. 41(2), pages 426-477, June.
  2. Marvin Goodfriend, 2000. "Overcoming the zero bound on interest rate policy," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 1007-1057.
  3. V.V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2002. "Can sticky price models generate volatile and persistent real exchange rates?," Staff Report 277, Federal Reserve Bank of Minneapolis.
  4. Coenen, Gunter & Wieland, Volker, 2003. "The zero-interest-rate bound and the role of the exchange rate for monetary policy in Japan," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 1071-1101, July.
  5. Jordi Galí & Mark Gertler & J. David López-Salido, 2007. "Markups, Gaps, and the Welfare Costs of Business Fluctuations," The Review of Economics and Statistics, MIT Press, vol. 89(1), pages 44-59, November.
  6. Tamim Bayoumi & Douglas Laxton & Paolo Pesenti, 2004. "Benefits and spillovers of greater competition in Europe: a macroeconomic assessment," International Finance Discussion Papers 803, Board of Governors of the Federal Reserve System (U.S.).
  7. 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.
  8. Svensson, L.E.O., 1993. "Term, Inflation and Foreign Exchange Risk Premia: A Unified Treatment," Papers 548, Stockholm - International Economic Studies.
  9. Canzoneri, Matthew B. & Cumby, Robert E. & Diba, Behzad T., 2005. "The need for international policy coordination: what's old, what's new, what's yet to come?," Journal of International Economics, Elsevier, vol. 66(2), pages 363-384, July.
  10. Clouse James & Henderson Dale & Orphanides Athanasios & Small David H. & Tinsley P.A., 2003. "Monetary Policy When the Nominal Short-Term Interest Rate is Zero," The B.E. Journal of Macroeconomics, De Gruyter, vol. 3(1), pages 1-65, September.
  11. Olivier Jeanne & Lars E. O. Svensson, 2004. "Credible Commitment to Optimal Escape from a Liquidity Trap; The Role of the Balance Sheet of an Independent Central Bank," IMF Working Papers 04/162, International Monetary Fund.
  12. 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.
  13. Obstfeld, Maurice & Rogoff, Kenneth, 2001. "Global Implications of Self-Oriented National Monetary Rules," Center for International and Development Economics Research, Working Paper Series qt6412m5b7, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  14. 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.
  15. 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.
  16. McCallum, Bennett T, 2000. "Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(4), pages 870-904, November.
  17. Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 139-235.
  18. 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).
  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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