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

47 Pages Posted: 12 Oct 2000 Last revised: 30 Sep 2022

See all articles by Lars E. O. Svensson

Lars E. O. Svensson

Stockholm School of Economics; Stockholm University - Institute for International Economic Studies (IIES); National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Date Written: October 2000

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 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.

Suggested Citation

Svensson, Lars E.O., The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap (October 2000). NBER Working Paper No. w7957, Available at SSRN: https://ssrn.com/abstract=245601

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