Escaping a liquidity trap through monetary policy: An overview of policy proposals

Jakob Brevinge

Student thesis: Master thesis

Abstract

A liquidity trap is a situation where the conventional monetary policy tool, the short-term interest rate, reaches or comes close to 0%. If the interest rate would be below 0% money would dominate bonds as an asset and therefore the central bank cannot lower the interest rate further when it has reached the zero boundary. Expansionary conventional monetary policy can in such a situation not be used to boost to the economy and has thereby lost its power. If the economy is in a downturn and require a low or even negative real interest to be fully employed the combination of a low or negative level of inflation and the zero boundary on nominal interest rate can create a situation where the economy cannot produce at its full capacity since the real interest rate cannot be as low as required. The decade long slump of the Japanese economy during the 90s and 00s showed the high costs to the economy of such a situation and has sparked a vivid debate among economists of what more unorthodox monetary policy measures that can be used to help an economy escape from a liquidity trap. The proposals can be divided into two categories, those directed at lowering the real interest rate by trying to lower the nominal interest rates or those directed at lowering the real interest rate by inducing inflation. Which types of methods that are most useful depend on the characteristics of the liquidity trap. In a liquidity trap with low or even negative inflation expectations measures directed at creating inflation, such as an inflation or price-level target or a devaluation of the exchange rate through a pegged exchange rate are most effective while in a liquidity trap where inflation expectations are still clearly positive and the yield curve is strongly upward sloping lowering long-term interest rates through open market operations or promises of a cap on long-term interest rate could be enough. Central for which method to use is not only the characteristic of the liquidity trap but also the issue of credibility. It is the belief that a monetary expansion can be reversed later on that makes conventional monetary policy ineffective at inducing inflation expectations. The same credibility problem can be seen with promises such as inflation or price-level targets as well as more simple promises such as the promise made by the Bank of Japan to continue to keep interest rates at zero “until deflationary concerns subside”. (Hayami 1999) In order to demonstrate resolve clear communication from the central bank, a mixture of monetary policy measures as well as combinations of expansionary fiscal and monetary policy are likely to be useful.

EducationsMSc in Finance and Strategic Management, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2009
Number of pages86