Scandinavian Working Papers in Economics

Seminar Papers,
Stockholm University, Institute for International Economic Studies

No 687: The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

Lars Svensson ()
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Lars Svensson: Institute for International Economic Studies, Stockholm University, Postal: Stockholm University, S-106 69 Stockholm, Sweden

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 an exchange-rate peg, which is later abandoned in favor of price-level or inflation targeting when the price-level target is reached. This will jump-start the economy 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 shift to price-level or inflation targeting will avoid the risk of overheating. Some conclusions for Japan are also included.

Keywords: Deflation; liquidity trap; nominal interest rates.

JEL-codes: E52; F31; F33; F41

53 pages, August 3, 2000

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