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

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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 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.

Published:

• Monetary and Economic Studies, Vol. 19, S1 (February 2001): 277-312 ,
• as "Escaping From A Liquidity Trap And Deflation: The Foolproof Way And Others," Journal of Economic Perspectives, Vol. 17, no. 4 (Autumn 2003): 145-166

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