Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others

Author:

Svensson Lars E.O1

Affiliation:

1. Professor of Economics at Princeton University, Princeton, New Jersey. He is also Research Fellow, Centre for Economic Policy Research, London, United Kingdom, and Research Associate, National Bureau of Economic Research, Cambridge, Massachusetts., .

Abstract

Existing proposals to escape from a liquidity trap and deflation, including my “Foolproof Way,” are discussed in the light of the optimal way to escape. The optimal way involves three elements: (1) an explicit central-bank commitment to a higher future price level; (2) a concrete action that demonstrates the central bank's commitment, induces expectations of a higher future price level and jump-starts the economy; and (3) an exit strategy that specifies when and how to get back to normal. A currency depreciation is a direct consequence of expectations of a higher future price level and hence an excellent indicator of those expectations. Furthermore, an intentional currency depreciation and a crawling peg, as in the Foolproof Way, can implement the optimal way and, in particular, induce the desired expectations of a higher future price level. I conclude that the Foolproof Way is likely to work well for Japan, which is in a liquidity trap now, as well as for the euro area and the United States, in case either would fall into a liquidity trap in the future.

Publisher

American Economic Association

Subject

Economics and Econometrics,Economics and Econometrics

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