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American Economic Review 97 (2007) 474-490
We start from two empirical facts: (1) Central banks target CPI inflation. (2) Independent central banks are concerned about their balance sheet and the level of their capital. The first fact makes it difficult for a central bank to implement the optimal escape from a liquidity trap, because it undermines a commitment to overshoot the inflation target. We show that the second fact provides a solution to this commitment problem. Capital concerns provide a mechanism for an independent central bank to commit itself to inflate ex post. The optimal policy can take the form of a currency depreciation combined with a crawling peg, a policy advocated by Svensson as the Foolproof Way to escape from a liquidity trap.
JEL Classification: E52, F31, F41
Keywords: Zero lower bound for interest rates, deflation.
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