Working Paper: CEPR ID: DP2566
Authors: 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 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.
Keywords: deflation; liquidity trap; nominal interest rates
JEL Codes: E52; F31; F33; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| announcing an upward-sloping price-level target path (E60) | increased inflation expectations (E31) |
| increased inflation expectations (E31) | stimulating economic activity (E65) |
| announcing an upward-sloping price-level target path (E60) | real depreciation of the domestic currency (F31) |
| real depreciation of the domestic currency (F31) | lower long real interest rates (E43) |
| lower long real interest rates (E43) | increased output gap (E23) |
| increased output gap (E23) | transition from deflation to inflation (E31) |
| credible peg (Y60) | positive nominal interest rate (E43) |
| positive nominal interest rate (E43) | facilitate exit from liquidity trap (E49) |