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

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Listed author(s):
  • 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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File URL: http://www.nber.org/papers/w7957.pdf
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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
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. Uhlig, Harald, 2000. "Should We Be Afraid of Friedman's Rule?," Journal of the Japanese and International Economies, Elsevier, vol. 14(4), pages 261-303, December.
  2. 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.).
  3. 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.
  4. Mervyn A. King, 1999. "Challenges for monetary policy : new and old," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 11-57.
  5. Robert L. Hetzel, 1999. "Japanese monetary policy: a quantity theory perspective," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 1-26.
  6. Gerlach, Stefan & Svensson, Lars E. O., 2003. "Money and inflation in the euro area: A case for monetary indicators?," Journal of Monetary Economics, Elsevier, vol. 50(8), pages 1649-1672, November.
  7. 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 219-239, March.
  8. Smets, Frank, 2000. "What horizon for price stability," Working Paper Series 0024, European Central Bank.
  9. Marvin Goodfriend, 2000. "Overcoming the zero bound on interest rate policy," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 1007-1057.
  10. Cushman, David O. & Zha, Tao, 1997. "Identifying monetary policy in a small open economy under flexible exchange rates," Journal of Monetary Economics, Elsevier, vol. 39(3), pages 433-448, August.
  11. Nelson, Edward, 2002. "Direct effects of base money on aggregate demand: theory and evidence," Journal of Monetary Economics, Elsevier, vol. 49(4), pages 687-708, May.
  12. Arturo Estrella & Jeffrey C. Fuhrer, 2002. "Dynamic Inconsistencies: Counterfactual Implications of a Class of Rational-Expectations Models," American Economic Review, American Economic Association, vol. 92(4), pages 1013-1028, September.
  13. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  14. 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.
  15. 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 841-858, September.
  16. Karen H. Johnson & David H. Small & Ralph W. Tryon, 1999. "Monetary policy and price stability," International Finance Discussion Papers 641, Board of Governors of the Federal Reserve System (U.S.).
  17. 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.
  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. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August.
  20. Leitemo,K., 1999. "Inflation targeting strategies in small open economies," Memorandum 21/1999, Oslo University, Department of Economics.
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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Bank of Japan at the Policy Frontier
    by Steve Cecchetti and Kim Schoenholtz in Money, Banking and Financial Markets on 2016-10-31 12:38:58
  2. Larry Elliott on HM Treasury and NGDP Targeting
    by Britmouse in uneconomical on 2012-08-28 21:16:39
  3. Learning from Japan: It's Hard to End a Deflation
    by Steve Cecchetti and Kim Schoenholtz in Money, Banking and Financial Markets on 2015-11-09 13:27:57
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