The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity TrapThe 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 presented, consisting of a price-level target path, a devaluation of the currency and a temporary exchange rate peg, which is later abandoned in favor 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. |
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aggregate demand aggregate-demand asset prices Bank of Japan base drift Bernanke central bank channel to aggregate conference Monetary Policy CPI inflation credible deflation denote devaluation discussed domestic inflation domestic interest rate equilibrium escaping exchange interventions exogenous expansionary expectations of future expected future real Federal Reserve Bank foolproof foreign inflation foreign-currency foreign-exchange interventions foreign-exchange market foreign-exchange reserves foreign-exchange risk premium forward-looking variables future real interest government bonds Hiroshi Fujiki increased inflation expectations inflation in period inflation target instrument rate interest parity Japanese Krugman 32 liquidity trap long real interest long-run inflation loss function Low Inflation Environment McCallum 38 Meltzer 45 monetary base Naohiko Baba nominal interest rate Okina one-period open economy open-market operations output gap Paper portfolio-balance effect price-level target path private sector real depreciation relative real exchange rate real interest rate Shigenori Shiratsuka Svensson 65 temporary peg Tokiko Shimizu transmission mechanism