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.