Working Paper: CEPR ID: DP2923
Authors: Willem H. Buiter
Abstract: The Paper studies the implications of the zero lower bound on the short nominal rate of interest for the conduct of monetary policy in a small open economy with a floating exchange rate and perfect international capital mobility. Monetary policy affects aggregate demand through the real exchange rate. When monetary policy follows a simplified Taylor rule for the short nominal interest rate, there exists a unique solution orbit that leads to the normal steady state. For any initial inflation rate below the target inflation rate (the normal steady-state rate of inflation under the Taylor rule), there also exists a continuum of other solution orbits that do not converge to the normal steady state but instead circle the liquidity trap steady state. Along these solution orbits, periods of rising inflation and excess demand alternate with periods of falling inflation and excess capacity. For some solution orbits, nominal interest rates are at the zero lower bound for all maturities ? the pure liquidity trap case. For others, nominal interest rates beyond a certain maturity will be positive.By adopting a rule for the short nominal interest rate on currency that systematically keeps it below the short nominal interest rate on non-monetary securities, the lower bound on the short nominal interest rate on non-monetary securities is eliminated and the liquidity trap disappears. This rule may involve paying negative interest on currency, or taxing currency. Proposals for taxing currency go back at least to Gesell. They inevitably involve non-trivial problems of administration and enforcement.
Keywords: Gesell; International Capital Mobility; Liquidity Trap; Taxing Money
JEL Codes: E41; E42; E43; E52; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| nominal interest rate on currency (E43) | demand for money (E41) |
| liquidity trap (E41) | monetary policy effectiveness (E52) |
| nominal interest rate on currency < nonmonetary securities (E43) | elimination of liquidity trap (E41) |
| fiscal policy (E62) | aggregate demand (E00) |
| Ricardian equivalence (H31) | effectiveness of fiscal measures (E62) |