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The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

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  • Lars E.O. Svensson

Abstract

The paper examines the transmission mechanism of monetary policy in an open economy with and without a binding zero bound on nominal interest rates. In particular, a foolproof way of escaping from a liquidity trap is presented, consisting of a price-level target path, a devaluation of the currency and a temporary exchange rate peg, which is later abandoned in favor of price-level or inflation targeting when the price-level target has been reached. This will jump-start the economy and escape deflation by a real depreciation of the domestic currency, a lower long real interest rate, and increased inflation expectations. The abandonment of the exchange-rate peg and the shift to price-level or inflation targeting will avoid the risk of overheating. Some conclusions for Japan are included.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7957.

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Date of creation: Oct 2000
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Publication status: published as Monetary and Economic Studies, Vol. 19, S1 (February 2001): 277-312
Handle: RePEc:nbr:nberwo:7957
Note: IFM ME
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Find related papers by 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

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  1. Marvin Goodfriend, 2000. "Overcoming the zero bound on interest rate policy," Working Paper 00-03, Federal Reserve Bank of Richmond.
  2. Uhlig, Harald, 2000. "Should We be Afraid of Friedman's Rule?," CEPR Discussion Papers 2548, C.E.P.R. Discussion Papers.
  3. Stefan Gerlach & Lars E.O. Svensson, 2000. "Money and Inflation in the Euro Area: A Case for Monetary Indicators?," NBER Working Papers 8025, National Bureau of Economic Research, Inc.
  4. 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.
  5. 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.
  6. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  7. Jordi Gali & Tommaso Monacelli, 1999. "Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Boston College Working Papers in Economics 438, Boston College Department of Economics, revised 15 Nov 1999.
  8. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August.
  9. Arturo Extrella & Jeffrey C. Fuhrer, 1998. "Dynamic inconsistencies: counterfactual implications of a class of rational expectations models," Working Papers 98-5, Federal Reserve Bank of Boston.
  10. David E. Lebow, 1993. "Monetary policy at near-zero interest rates," Working Paper Series / Economic Activity Section 136, Board of Governors of the Federal Reserve System (U.S.).
  11. David O. Cushman & Tao Zha, 1995. "Identifying monetary policy in a small open economy under flexible exchange rates," Working Paper 95-7, Federal Reserve Bank of Atlanta.
  12. Hallman, Jeffrey J & Porter, Richard D & Small, David H, 1991. "Is the Price Level Tied to the M2 Monetary Aggregate in the Long Run?," American Economic Review, American Economic Association, vol. 81(4), pages 841-58, September.
  13. Karen Johnson & David Small & Ralph Tryon, 1999. "Monetary policy and price stability," International Finance Discussion Papers 641, Board of Governors of the Federal Reserve System (U.S.).
  14. Smets, Frank, 2000. "What horizon for price stability," Working Paper Series 0024, European Central Bank.
  15. Fuhrer, Jeffrey C & Moore, George R, 1995. "Monetary Policy Trade-offs and the Correlation between Nominal Interest Rates and Real Output," American Economic Review, American Economic Association, vol. 85(1), pages 219-39, March.
  16. Robert L. Hetzel, 1999. "Japanese monetary policy: a quantity theory perspective," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 1-26.
  17. Leitemo,K., 1999. "Inflation targeting strategies in small open economies," Memorandum 21/1999, Oslo University, Department of Economics.
  18. 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.
  19. Mervyn King, 1999. "Challenges for monetary policy : new and old," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 11-57.
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  1. Larry Elliott on HM Treasury and NGDP Targeting
    by Britmouse in uneconomical on 2012-08-28 21:16:39
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