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The Zero Bound in an Open Economy:
A Foolproof Way of Escaping from a Liquidity Trap

Lars E.O Svensson
Princeton University and Stockholm University;
CEPR and NBER

Monetary and Economic Studies 19(S-1), February 2001, 277-312,

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.

JEL Classification: E52, F31, F33, F41
Keywords: Deflation, liquidity trap, nominal interest rates.

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The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

Lars E.O Svensson Princeton University and Stockholm University; CEPR and NBER

Monetary and Economic Studies 19(S-1), February 2001, 277-312,

The Zero Bound in an Open Economy:
A Foolproof Way of Escaping from a Liquidity Trap

Lars E.O Svensson
Princeton University and Stockholm University;
CEPR and NBER