Confidence in future monetary policy as a way to overcome the liquidity trap

Abstract

The global financial crisis of 2007–2009 has changed the landscape for monetary policy. Many central banks in developed economies had to employ various unconventional policy tools to overcome a liquidity trap. These included large-scale asset purchase programs, forward guidance and negative interest rate policies. While recently, some central banks were able to return to conventional monetary policy, for many countries the effectiveness of unconventional policies remains an issue. In this paper we assess diverse practices of unconventional monetary policy with a particular focus on expectations and time consistency. The principal aspect of successful policy in terms of overcoming a liquidity trap is the confidence that interest rates will remain low for a prolonged period. However, forming such expectations faces the problem of time inconsistency of optimal policy. We discuss some directions to solve this problem.