Academic journal article NBER Reporter

Liquidity Traps, Policy Rules for Inflation Targeting, and Eurosystem Monetary-Policy Strategy. (Research Summaries)

Academic journal article NBER Reporter

Liquidity Traps, Policy Rules for Inflation Targeting, and Eurosystem Monetary-Policy Strategy. (Research Summaries)

Article excerpt

The field of monetary policy continuously provides new challenges for economic research. For instance, the experience of Japan since the early 1990s has generated new work on how to avoid and escape from a liquidity trap. The rapid spread of inflation targeting during the 1990s has stimulated new studies of how to understand and further improve this monetary policy regime. The ever-present uncertainty in practical monetary policymaking provides a constant demand for new ideas about conducting monetary policy under uncertainty. And, the controversial choice of a monetary policy strategy for the euro area has encouraged further research on monetary indicators and monetary targeting. These are all areas of focus in my own research over the last few years. (1)

Escaping from a Liquidity Trap: The Foolproof Way

Japan's decade-long experience of deflation and a "liquidity trap" has stimulated research on how to escape from such a trap. In a liquidity trap, the central bank's "instrument rate" -- a short nominal interest rate, such as the federal funds rate in the United States -- is zero and the zero lower bound is binding, in the sense that deflation and/or recession calls for a more expansionary policy and a lower real interest rate.

As several authors have pointed out, an open economy such as Japan's has access to a very effective stimulative measure -- namely, a currency depreciation -- if it wants to avoid a deflationary spiral. From that insight, I have constructed a specific proposal for a foolproof way to escape from a liquidity trap. (2) Although this proposal was directed initially to the Bank of Japan (BOJ) and the Ministry of Finance of Japan (MOF) -- because the MOF is formally in charge of exchange rate policy in Japan -- the foolproof way provides a method for any sufficiently open economy to escape from a liquidity trap, if it so desires. (3)

The idea is to announce and implement 1) an upward-sloping target path for the price level; 2) a depreciation and a temporary peg of the currency; and 3) the future abandonment of the peg in favor of inflation targeting when the price-level target path has been reached. The price-level target path provides the best nominal anchor and insurance against run-away inflation. It also provides an exit strategy for the temporary peg. The target path begins somewhere above the current price level; that difference is the "price gap." In Japan, several years of zero or negative inflation (that is, deflation) have resulted in a price level below previous expectations, increasing the real value of debt and contributing to deteriorating balance sheets for firms and banks. For Japan, the price gap may be 10-20 percent or more. The upward slope corresponds to a small positive long-run inflation target, say, 2 percent/year.

How to achieve this price-level target? This is the role of the depreciation and the temporary peg of the currency. Both are technically feasible. If the peg would fail, then the currency would appreciate back to where it was, making it a good investment. Initially, before the peg's credibility has been established, there will therefore be excess demand for the currency. This is fulfilled easily, though, because the central bank can print unlimited amounts of the currency and sell them for foreign exchange. Indeed, there is a big difference between defending a fixed exchange rate for a strong currency under appreciation pressure (when foreign exchange reserves rise) and for a weak currency under depreciation pressure (when foreign exchange reserves fall). Thus, the peg can be maintained, and after a day or perhaps a few days, the peg's credibility will have been established.

Further, in order to be effective, the initial depreciation of the currency needs to be so large that it results in a real depreciation relative to any conceivable long-run equilibrium real. exchange rate. For Japan, this may require a peg at 140 or 150 yen to the dollar, or even more. …

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