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The Case for Open-Market Purchases in a Liquidity Trap

  • Alan Auerbach

    (Economics Department, University of California, Berkeley)

  • Maurice Obstfeld

    (Economics Department, University of California, Berkeley)

Prevalent thinking about liquidity traps suggests that the perfect substitutability of money and bonds at a zero short-term nominal interest rate renders open-market operations ineffective for achieving macroeconomic stabilization goals. We show that even were this the case, there remains a powerful argument for large-scale open market operations as a fiscal policy tool. As we also demonstrate, however, this same reasoning implies that open-market operations will be beneficial for stabilization as well, even when the economy is expected to remain mired in a liquidity trap for some time. Thus, the microeconomic fiscal benefits of open-market operations in a liquidity trap go hand in hand with standard macroeconomic objectives. Motivated by Japan's recent economic experience, we use a dynamic general-equilibrium model to assess the welfare impact of open-market operations for an economy in Japan's predicament. We argue Japan can achieve a substantial welfare improvement through large open-market purchases of domestic government debt.

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Paper provided by EconWPA in its series Macroeconomics with number 0407009.

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Length: 61 pages
Date of creation: 07 Jul 2004
Date of revision:
Handle: RePEc:wpa:wuwpma:0407009
Note: 61 pages
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