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

  • Lars E.O. Svensson

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
Date of revision:
Publication status: published as Monetary and Economic Studies, Vol. 19, S1 (February 2001): 277-312
Handle: RePEc:nbr:nberwo:7957
Note: IFM ME
Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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  1. 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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  3. 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.).
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  8. Gerlach, Stefan & Svensson, Lars E O, 2002. "Money and Inflation in the Euro-Area: A Case for Monetary Indicators?," CEPR Discussion Papers 3392, C.E.P.R. Discussion Papers.
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  13. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August.
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  17. Leitemo,K., 1999. "Inflation targeting strategies in small open economies," Memorandum 21/1999, Oslo University, Department of Economics.
  18. Robert L. Hetzel, 1999. "Japanese monetary policy: a quantity theory perspective," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 1-26.
  19. 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.).
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