Shaping public confidence as a way to overcome a liquidity trap

Abstract

In the aftermath of 2007—2009 global financial crisis, many economies had stuck in a liquidity trap. This stance forced central banks to implement various unconventional monetary policies, including massive purchases of financial assets, cutting policy rates down into the negative zone and reliance on forward guidance. In this paper we critically discuss these policy measures. Unconventional policy success in overcoming a liquidity trap heavily depends on the ability to manage private agents’ expectations. If the central bank is capable to form expectations of low interest rates for a prolonged period after the escape from a liquidity trap, unconventional monetary policies lead to a recovery. Another crucial issue is dynamic inconsistency of prolonged low interest rate policy. We discuss several ways of how the central bank can commit not to lift policy rate up to keep inflation unnecessary low. The problem of dynamic inconsistency, which complicates the formation of such expectations, is also considered, and possible ways of solving this problem are discussed.