DP2566 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, Nominal Interest Rates|
|JEL(s):||E52, F31, F33, F41|
|Programme Areas:||International Macroeconomics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=2566|
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.