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Discussion Paper Details

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

Author(s): Lars E.O. Svensson

Publication Date: September 2000

Keyword(s): Deflation, Liquidity Trap and Nominal Interest Rates

Programme Area(s): International Macroeconomics

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 suggested, consisting of a price-level target path, a devaluation of the currency and a temporary exchange rate peg, which is later abandoned in favour 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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Bibliographic Reference

Svensson, L. 2000. 'The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=2566