Working Paper: NBER ID: w10195
Authors: Lars E.O. Svensson
Abstract: Existing proposals to escape from a liquidity trap and deflation, including my Foolproof Way,' are discussed in the light of the optimal way to escape. The optimal way involves three elements: (1) an explicit central-bank commitment to a higher future price level; (2) a concrete action that demonstrates the central bank's commitment, induces expectations of a higher future price level and jump-starts the economy; and (3) an exit strategy that specifies when and how to get back to normal. A currency depreciation is a direct consequence of expectations of a higher future price level and hence an excellent indicator of those expectations. Furthermore, an intentional currency depreciation and a crawling peg, as in the Foolproof Way, can implement the optimal way and, in particular, induce the desired expectations of a higher future price level. I conclude that the Foolproof Way is likely to work well for Japan, which is in a liquidity trap now, as well as for the euro area and the United States, in case either would fall into a liquidity trap in the future.
Keywords: No keywords provided
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 |
|---|---|
| Central bank commitment to a higher future price level (E52) | Expectations of inflation (E31) |
| Expectations of inflation (E31) | Real interest rates (E43) |
| Real interest rates (E43) | Economic activity (E29) |
| Currency depreciation (F31) | Expectations of a higher future price level (D84) |
| Crawling peg (F31) | Central bank commitment to a higher future price level (E52) |
| Crawling peg (F31) | Real interest rates (E43) |
| Crawling peg (F31) | Aggregate demand (E00) |
| Central bank credibility (E58) | Currency depreciation (F31) |
| Currency depreciation (F31) | Economic recovery from a liquidity trap (E19) |