Monetary Policy in a Liquidity Trap

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					              Monetary Policy in a Liquidity Trap*
                                                         BY MICHAEL DOTSEY

                  n the United States, the Federal Reserve sets                               fundamentals generally attains both
                                                                                              the most efficient level of output1 and
                  monetary policy by targeting the federal funds                              an inflation rate consistent with long-
                  rate. This process usually involves lowering                                run inflation objectives.
                                                                                                     This process usually involves
                  short-term interest rates when economic                                     lowering short-term interest rates when
   growth is weak and raising them when economic growth                                       economic growth is weak or inflation
                                                                                              or expected inflation is below some
   is strong. A wide class of economic models has shown                                       desired rate and raising them when the
   that, in theory, conducting policy in this way allows the                                  economy is growing strongly or when
                                                                                              inflation or expectations of inflation
   economy to employ resources efficiently. In addition, many                                 are high. It has been theoretically
   empirical studies have shown that most central banks                                       shown in a wide class of economic
                                                                                              models that conducting policy in this
   actually behave in this manner. In normal times, it is fairly                              way allows the economy to employ
   easy for the central bank to conduct policy in this fashion.                               resources efficiently. Low and stable
                                                                                              inflation is a desirable feature of a well-
   But there is one instance when conducting policy in this                                   managed economy, and setting the
   manner becomes problematic: when the economy finds                                         interest rate in a pro-cyclical manner is
                                                                                              consistent with economic efficiency.
   itself in a “liquidity trap,” a situation in which the short-                                    This way of conducting monetary
   term nominal interest rate is zero or very close to zero. In                               policy is not just theoretically
                                                                                              sound. Many empirical studies have
   this article, Mike Dotsey analyzes the difficulties a central
                                                                                              shown that most central banks
   bank faces in such circumstances and discusses the tools                                   actually behave in this manner. This
                                                                                              description of monetary policy —
   available to monetary policymakers. Policy as usual is not
                                                                                              varying the interest rate in response to
   an option, and the central bank’s framework for                                            inflation and economic activity — is
                                                                                              called a Taylor rule or a Taylor-type
   conducting policy must change.
                                                                                              rule, named after John Taylor, who first
                                                                                              described these types of policies.
     Monetary policy typically operates         States, the Federal Reserve targets the             In normal times it is fairly easy
by targeting a short-term interest              federal funds rate. In order to conduct       for the central bank to conduct policy
rate. For example, in the United                monetary policy, central banks                according to a Taylor-type rule. But
                                                generally vary the short-term interest        there is one instance when conducting
                                                rate target in response to economic           policy in this manner becomes
                           Mike Dotsey is a     conditions. They do so because
                           vice president and                                                 problematic: when the economy finds
                           senior economic
                                                setting the short-term interest rate          itself in a “liquidity trap,” which is
                           policy advisor       at a level consistent with economic           defined as a situation in which the
                           in the Research
                           Department of
                           the Philadelphia
                           Fed. This article    *The views expressed here are those of the     The efficient level of output is the output
                           is available free    author and do not necessarily represent       that would occur if all prices and wages were
                           of charge at www.    the views of the Federal Reserve Bank of      continuously adjusted in response to changes in          Philadelphia or the Federal Reserve System.   economic conditions.
publications/.                                                                                            Business Review Q2 2010 9
short-term nominal interest rate is zero    follows will be a fairly abbreviated           is very weak, the real interest rate may
or very close to zero.                      analysis.2                                     even become negative. A negative real
     Because the nominal interest                The real interest rate, defined as        interest rate is sometimes observed
rate is generally bounded below by          the nominal interest rate less expected        during recessions.
zero, the central bank cannot lower         inflation, plays an important role in               Generating a Liquidity Trap. If
interest rates further even if it would     determining what fraction of output            the economy is sufficiently weak that a
be desirable to do so, as it would be if    is consumed and what fraction is in-           real interest rate below zero is desir-
the economy were in a deep recession.       vested. In a perfectly competitive econ-       able, it is possible for the economy to
Furthermore, as I’ll discuss below, in      omy, the movement of the real interest         enter a liquidity trap. As indicated
this situation, trying to stimulate the     rate in response to economic shocks is         above, the real interest rate is defined
economy by injecting more money             consistent with the optimal allocation         as the nominal interest rate minus the
or liquidity through open market            of economic resources. That is, the            expected rate of inflation. But this
operations may have little or no effect
on output. Therefore, it may appear
that monetary policy is impotent under
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     This article analyzes the
difficulties a central bank faces in such
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circumstances and discusses the tools       IUDFWLRQ RI RXWSXW LV FRQVXPHG DQG
available to monetary policymakers.         ZKDW IUDFWLRQ LV LQYHVWHG
Policy as usual is not an option,
and the central bank’s framework
for conducting policy must change.          real rate responds in such a way that          means that the nominal interest rate
Importantly, it must change in ways         the level of output and its allocation         is the sum of two components: the real
that alter individuals’ expectations of     between consumption and investment             interest rate and the expected rate of
what policy will be like when the zero      is the one that provides the highest           inflation. This relationship is known
lower bound on interest rates is no         level of economic welfare. This interest       as the Fisher equation. Importantly,
longer binding.                             rate, which is associated with perfect         the nominal interest rate cannot be
      Thus, the conduct of monetary         competition, is generally referred to          negative because no one would lend at
policy becomes quite subtle and             as the economy’s natural interest rate.        a negative rate. If they did, they would
depends on the credibility of proposed      For example, strong economic growth            get less money back than they lent,
future actions. Further, economists         is associated with an opportune time           and they would be better off putting
have been concerned about the design        to make investments, especially if             their money in their mattress. Thus,
of appropriate monetary policy in a         that growth is generated by increased          in a liquidity trap, when the nominal
liquidity trap for quite some time, and     productivity. At such times, consum-           interest rate is zero and a negative
in what follows, I will draw heavily        ers are also wealthier and hence desire        real interest rate is also desirable, the
on the work of Gauti Eggertsson and         more consumption. In order to induce           Fisher equation implies that expected
Michael Woodford; Alan Auerbach             enough saving for financing the opti-          inflation must be equal and of opposite
and Maurice Obstfeld; and Paul              mal quantity of investment, the real           sign to this negative real interest rate.
Krugman.                                    interest rate rises. Thus, resources are       Therefore, the desirability of a negative
                                            allocated toward increasing the capital        real interest rate implies the desirabil-
ECONOMIC PROBLEMS                           stock, which, in turn, results in higher       ity of positive expected inflation.
ASSOCIATED WITH A                           future output, higher future consump-               If features of the economy prevent
LIQUIDITY TRAP                              tion, and higher wages. Analogously,           prices from adjusting flexibly, expected
      To understand the economic            when the economy is weak, the real in-         inflation may, in the end, not be
problems that ensue when an economy         terest rate falls, and when the economy        high enough to generate a sufficiently
is in a liquidity trap, we must first                                                      low real interest rate. The monetary
understand the concept of the real                                                         authority is also unable to lower the
interest rate and its role in efficiently   2
                                             For a more detailed discussion, see my 2004   nominal rate below zero. Thus, in ad-
allocating economic resources. What         Business Review article.                       dition to the economic shocks that are

10 Q2 2010 Business Review                                                                        
responsible for the recession, interest              affect economic activity. Moreover,          rate to the natural rate would require a
rates cannot adjust in an optimal way.               this type of policy is consistent with       nominal rate of -2.0 percent, which is
The presence of the liquidity trap                   a policy of low and stable inflation.        impossible.
places the economy in even greater                   Only policy changes that move the                 This higher-than-natural real
jeopardy. Furthermore, because money                 real interest rate by larger amounts         rate will serve to choke off aggregate
and bonds are now perfect substi-                    than dictated by underlying economic         demand beyond what occurs due
tutes — each is earning a zero rate of               fundamentals have a substantive effect       to economic disturbances, and the
interest — the inflation rate is not a               on inflation and economic activity. For      economy will be in for a deeper reces-
current monetary policy phenomenon.                  example, a severe tightening of policy       sion than it otherwise would be. This
The fact that both assets are now                    raises the short-term real interest rate     is the situation in which the liquidity
earning the same zero rate of interest               above its efficient or natural level, tem-   trap has severe consequences and why
implies that the public is indifferent               porarily choking off consumption and         all central banks endeavor to keep the
between the relative amounts of money                investment. The tightening of policy         economy out of these circumstances.
and bonds in its portfolio.3 Therefore,              also brings down inflation. A good                As discussed, this is also the situa-
current open market operations that                  example is the disinflation during the       tion in which the nominal rate cannot
alter the amount of bonds and money                  tenure of Fed Chairman Paul Volcker,         be lowered further, and standard mon-
in public hands have no impact on
inflation. Second, with no opportunity               ,Q QRUPDO WLPHV VWDQGDUG HFRQRPLF PRGHOV
cost for holding money, the public is
willing to hold just about any amount
                                                     VXJJHVW WKDW D FHQWUDO EDQN VKRXOG DGMXVW WKH
of money the central bank supplies.                  VKRUWWHUP QRPLQDO LQWHUHVW UDWH RQHIRURQH
Thus, current injections of money                    ZLWK SHUFHLYHG PRYHPHQWV LQ WKH UHDO
have little effect on prices or inflation.
This is why the occurrence of a zero                 LQWHUHVW UDWH
nominal interest rate is called a liquid-
ity trap.                                            when the Fed maintained very high            etary policy that relies on simple Tay-
      However, future monetary policy                nominal and real interest rates. This        lor-style interest rate rules is helpless
can prove effective in the current                   policy contributed to the two ensuing        in ameliorating the weakness in the
environment, but understanding the                   recessions and a significant lowering of     economy. Unfortunately for Japan in
subtle and indirect way in which that                the inflation rate. The opposite occurs      the 1990s and the U.S. economy today,
happens requires an understanding of                 when the central bank reduces the real       this is where we find ourselves. Fortu-
how monetary policy affects prices in                interest rate below its natural rate. The    nately, there are policies the central
more normal times.                                   result is temporarily higher output and      bank can follow that will mitigate the
      Controlling the Price Level and                an increase in the inflation rate.           effects of the liquidity trap, but policies
Inflation. In normal times, standard                      However, a liquidity trap is a time     in this situation involve departing from
economic models suggest that a central               when the central bank would like to          normal operating procedures and the
bank should adjust the short-term                    bring the real rate down. Therefore, in      rules that normally govern monetary
nominal interest rate one-for-one with               theory, the central bank should desire       policy. As a result, these alternative
perceived movements in the real inter-               an increase in near-term inflation that      policies may be difficult to communi-
est rate. This type of policy engenders              makes the real interest rate negative        cate, and because liquidity traps are
an efficient economic response to the                enough so that the economy is able to        rare events, these policies may not be
various types of disturbances that                   best cope with the fundamental factors       deemed fully credible since the public
                                                     that have reduced output growth. For         has little experience with these situa-
                                                     example, suppose the natural real in-        tions, as well.
                                                     terest rate is -3.0 percent and inflation
 Currency earns a zero rate of interest and other    expectations are 1.0 percent. The zero       MONETARY POLICY IN THE
types of money, such as bank reserves, have,
until quite recently, earned a zero rate of inter-   lower bound on nominal interest rates        LIQUIDITY TRAP
est. When short-term bonds, such as Treasury         implies that the real interest rate in            Credibility is an essential feature
bills, earn a positive rate of interest, holding
money incurs an opportunity cost in terms of
                                                     financial markets can, at best, be low-      of the simple policy I will discuss
forgone interest.                                    ered to -1.0 percent. To lower the real      and a feature of any successful                                                                                             Business Review Q2 2010 11
monetary policy during a liquidity                fortunately, appear to be temporary       economic activity more than offsets
trap, and it may be an even more                  phenomena.                                the cost of somewhat higher inflation.
important ingredient than when the                     Role of Nominal Interest             But because the commitment pertains
economy is functioning under normal               Rate in a Liquidity Trap. We have         to future actions, it will have an effect
circumstances.4 The reason is that                emphasized that there is nothing          only if the policy is believed. This
the central bank must depart from                 current monetary policy can               feature is an important component
its normal behavior, and the public,              accomplish while the economy is in a      of the influential work of Gauti
having little experience with a liquidity         liquidity trap. However, once economic    Eggertsson and Michael Woodford,
trap, may not believe that policy has             activity recovers to the point at which   who have analyzed the liquidity
actually changed. Absent perfect                  the nominal interest rate is positive,    trap in great depth. An important
credibility, the policies described below         monetary policy can influence the         theme resonating throughout their
would lead to very different and much             level of economic activity. So at some    analysis is policy’s ability to influence
less beneficial economic outcomes.
      If the economy is in a liquidity
trap and the weakness in the economy              ,Q D VWDQGDUG WKHRUHWLFDO PRGHO D
is significant, it may be desirable               commitment by the central bank to
to generate an increase in inflation
expectations. In our previous example,
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lowering the financial real interest              ZKDW LW ZRXOG EH LQ WKH DEVHQFH RI D
rate to a desirable -3.0 percent requires         OLTXLGLW\ WUDS LV D EHQH¿FLDO SROLF\ UHVSRQVH
inflation expectations to increase to
3.0 percent. However, doing so requires           ZKHQ WKH HFRQRP\ LV LQ D OLTXLGLW\ WUDS
the public to believe that future
inflation will indeed reach 3.0 percent.          point in the future, a lower-than-        expectations and, importantly,
      The success of altering future              normal future short-term nominal          inflationary expectations over long
policy also requires that the economy             interest rate will stimulate future       horizons. By doing so, the monetary
not be in the liquidity trap forever.             economic activity.                        authority influences the term structure
Historically, all instances of actual                  Generating increased output          of real interest rates and thereby
liquidity traps have been temporary.              growth in the future can have             influences current aggregate demand.5
The current crisis appears to be                  consequences for current output.          So, even in an environment where
temporary as well, and it appears                 Investment now becomes more               both prices and inflation respond
that the public believes this to be the           attractive, and firms may be reluctant    slowly to economic shocks and
case. That inference is based on the              to lay off as many workers if they        monetary policy, the policies prescribed
fact that long-term interest rates are            are confident that higher than            by Eggertsson and Woodford have
currently positive. Because long-                 normal output is around the corner.       substantial effects.
term interest rates are an average of             Expectations of better times ahead will        In their work, Eggertsson and
current and future short-term interest            also stimulate current consumption.       Woodford show that the zero bound
rates, a positive long-term interest              The cost of the future monetary           can cause a significant problem for
rate implies that at some point in the            stimulus will be that future inflation    monetary policy in the case in which
future short-term interest rates will be          would be higher than it otherwise         the interest rate rule does not change
positive as well. Hence, the evidence             would have been.                          when the economy exits the liquidity
from long-term bond markets indicates                  Thus, in a standard theoretical      trap. That is, a Taylor-type rule that
that the zero lower bound will not                model a commitment by the central         works fine in normal times may not
last indefinitely. Liquidity traps,               bank to temporarily increase future       work so well when there is a zero lower
                                                  inflation above what it would be          bound problem.
                                                  in the absence of a liquidity trap is
                                                  a beneficial policy response when
 For a discussion of the importance of cred-      the economy is in a liquidity trap.       5
ibility in general, see my 2008 article and the                                              The term structure of interest rates describes
Federal Reserve Bank of Philadelphia’s 2007
                                                  The central bank makes such a             the relationship between interest rates on bonds
annual report.                                    commitment because the gain in            of varying maturities.

12 Q2 2010 Business Review                                                                            
     A particularly important result             the increase must be permanent. By             greater output growth in the future.
of their analysis is that many poli-             necessity, the underlying interest rate        The increase in future output growth
cies advocated in the popular press              rule must change once the economy              implies greater output growth in the
when the economy is in a liquidity               escapes from the zero lower bound. If          present, when the zero lower bound is
trap with zero nominal interest rates            policy returns to a normal interest rate       binding, and implies that the natural
are not useful. In particular, in their          rule, the money injected during the li-        interest rate is somewhat higher in the
framework, not only are current open             quidity trap will have to be withdrawn         current environment than it would be
market operations, which exchange                to ward off an increase in the inflation       absent the promise of future inflation.
short-term bonds for money, irrelevant,          rate. But this action would be inconsis-       Thus, Eggertsson and Woodford show
but temporarily providing additional
bank reserves through increased open
market operations will have no effect            $ SROLF\ WKDW SHUPDQHQWO\ FKDQJHV WKH
on the economy, irrespective of the              PRQHWDU\ EDVH WRGD\ PXVW DOVR EH DVVRFLDWHG
types of assets the monetary authority
purchases.                                       ZLWK D FKDQJH LQ WKH LQWHUHVW UDWH UXOH LI LW
     This last result occurs because ef-         LV WR KDYH HIIHFWV ,W LV QRW MXVW WKH FXUUHQW
ficient pricing of, say, long-term bonds
that are currently yielding a positive
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interest rate can have an effect on              EXW WKH SDWK WKDW SROLF\ VHWV IRU IXWXUH
behavior only if those purchases imply
                                                 VKRUWWHUP LQWHUHVW UDWHV PDWWHUV DV ZHOO
a change in the path of short-term
rates. This is because, as mentioned,
long-term rates are merely an average            tent with the higher inflation promised        that the economic losses associated
of short-term rates.6 Thus, any policy           while the economy was in the liquid-           with a real interest rate that is too low
response today that does not also re-            ity trap. Hence, if the public believes        can be reduced.
flect a change in future policy will not         that upon exiting the liquidity trap the
affect future economic activity. There-          central bank would immediately return          A SPECIFIC POLICY
fore, it will not affect future short-term       to normal policy, the promise of ad-                Eggertsson and Woodford provide
interest rates and hence should not              ditional near-term inflation would not         specific policy advice for the central
affect the long-term bond rate in any            have been believed in the first place.         bank when a liquidity trap occurs.
meaningful way.                                        Thus, a policy that permanently          The specifics of their proposal are
     Two features of their model are             changes the monetary base today must           complex and particular to their
responsible for the ineffectiveness of           also be associated with a change in the        model. However, they suggest that
large-scale increases in central bank            interest rate rule if it is to have effects.   dealing with the public’s expectations
liabilities, often called quantitative           It is not just the current setting of the      when the economy is in a liquidity
easing: (1) any increases in money at            interest rate that is important, but the       trap will take some skill on the part
the zero bound is done through open              path that policy sets for future short-        of any central bank. Interestingly,
market operations and, therefore,                term interest rates matters as well. This      in their framework, a simple price-
does not affect the value of govern-             is analogous to saying that the system-        level targeting rule comes very close
ment liabilities, and (2) any increase           atic component of policy is important          to achieving the best outcome, and
in money, even if it is accomplished             and that more importance should be             such a policy should be relatively
via government transfers, is transi-             attached to what will be done in the           easy to communicate. Rather than
tory. Thus, as in the analysis by Alan           future than what is done today.                targeting inflation per se, as is typical
Auerbach and Maurice Obstfeld, for                     But there is an additional subtlety      of most central bank behavior, in a
increases in money to be beneficial,             here. As mentioned, a change in future         liquidity trap, the central bank should
                                                 policy implies that the central bank           actually target the path of prices.7 The
                                                 must tolerate additional inflation in
                                                 the future even after the zero bound is
 Eggertsson and Woodford’s argument is in fact
more general and encompasses the govern-
                                                 no longer a problem. This policy leads         7
                                                                                                 For a detailed discussion of price-level target-
ment’s purchase of any asset.                    to less deflation at the zero bound and        ing, see the article by Alexander Wolman.                                                                                              Business Review Q2 2010 13
important distinction is that a price             a central bank to buy large quantities               Without full credibility, it is hard
path implies that should inflation                of long-term debt as a way of signaling              to generate an increase in inflation
be relatively low today so that the               its intention to increase near-term                  beyond what the public would
price level is below its target, future           inflation and inflation expectations. In             normally expect, and if that inflation
inflation must increase to get the price          this case, not carrying through on its               is generated, it subsequently may be
level back on track. Therefore, the               implied promise would result in a fall               difficult to return expectations of
occurrence of deflation would require             in bond prices and a capital loss for the            inflation to ones that are consistent
higher future inflation, and as we have           central bank.9                                       with price stability. As discussions in
seen, somewhat higher than normal                                                                      the media suggest, the current large
inflation is a useful mechanism for               A LARGE INCREASE IN THE                              increase in the Federal Reserve’s
ameliorating the adverse effects of a             FED’S BALANCE SHEET                                  balance sheet could represent such a
liquidity trap.8                                       However, a potential challenge                  threat to the credibility of the Fed’s
      A price-level target is a way of            from the standpoint of the monetary                  long-run inflation target.10
formalizing that policy prescription.             authority is that once higher short-                      The concern being expressed is
Because no central bank employs a                 term inflation is realized, the public               that if it becomes difficult to unwind
price-level target, that could make               will alter its expectations of inflation             some of the assets currently on the
credibility for this option problematic.          and the central bank will now be                     balance sheet, the future money supply
The proposal could be couched as a                facing an inflation scare and the                    could be permanently higher. However,
time-varying inflation target, whereby            problems that accompany a departure                  with interest rates returning to normal
the targeted inflation rate would be              of inflation expectations from target.               levels, the demand for money will not
the rate that would get prices back to                                                                 be permanently higher. A permanent
the price-level path. But, again, the                                                                  increase in the money supply without a
                                                  A lack of perfect
public has little experience with such                                                                 permanent increase in money demand
a rule. Thus, establishing credibility            FUHGLELOLW\ ZKLFK PD\                               can only lead to higher prices and
for future expansionary policy is an              be an unavoidable                                    higher inflation.
essential, but perhaps difficult, feature                                                                   Currently, there is every
of successful policy at the zero lower            UHDOLW\ DFWV DV D WZR                              expectation that the Fed will
bound.                                            HGJHG VZRUG WKDW                                     successfully reduce its balance sheet
      Thus, a central message of                                                                       as the banking system recovers, and
Eggertsson and Woodford’s research is
                                                  PDNHV GHDOLQJ ZLWK D                                 survey data on inflation expectations
that the monetary authority must be               OLTXLGLW\ WUDS GLI¿FXOW                             confirm this belief. Managing that
able to commit to expansionary policy                                                                  expectation is thus an important part
once the zero-lower-bound problem                 Problems such as these have been well                of policy, as evidenced in a number
is alleviated. In particular, it must             documented in Marvin Goodfriend’s                    of speeches by Federal Reserve
commit to higher inflation than would             study and discussed in my essay with                 policymakers, including Philadelphia
otherwise occur if the zero bound                 Charles Plosser.                                     Fed President Charles Plosser.11 It has
had not been reached. A proposal of                    Thus, a lack of perfect credibility,            become increasingly important for
raising the price of long-term debt               which may be an unavoidable reality,                 the Federal Open Market Committee
or, equivalently, lowering long-term              acts as a two-edged sword that makes                 (FOMC) to articulate an exit strategy
interest rates is consistent with the             dealing with a liquidity trap difficult.             and to indicate to the public that
optimal lower future path of short-term                                                                it will follow an exit strategy that
rates. It could, therefore, be useful for                                                              does not ignite future inflation.
                                                   Alternatively, as Lars Svensson has suggested,
                                                  the central bank could deflate the value of the
                                                  currency using an exchange-rate peg. Doing so
8                                                                                                      10
 In other models, such as the one in the study    would require purchasing foreign assets, and           The size of the Federal Reserve’s balance sheet
by Andrew Levin, David Lopez-Salido, Edward       this policy may also be useful in establishing       has more than doubled from $954 billion on
Nelson, and Tack Yun, a price-level target does   credibility for higher inflation. If higher infla-   September 17, 2008, to slightly more than $2
not duplicate optimal policy nearly as well.      tion is not forthcoming, the home currency           trillion as of August 26, 2009.
Their model calls for even more aggressive        would appreciate, and the foreign assets on the
policy, which leads to a permanent increase in    central bank’s balance sheet would depreciate,         See, for example, the speech by Charles
the price-level path.                             resulting in a capital loss for the central bank.    Plosser.

14 Q2 2010 Business Review                                                                                        
Indeed, the FOMC has been quite               future inflation is helpful, this may be   could face a future destabilization
explicit concerning its intentions for        difficult to achieve because standard      of inflation expectations and all the
maintaining long-run price stability.         monetary policy that targets a nominal     problems that ensue when that occurs.
                                              interest rate is ineffective once               Thus, a liquidity trap is a
SUMMARY                                       nominal interest rates have reached        perilous place for the economy
     This article describes the               zero. Achieving the necessary increase     and a central bank. Successfully
difficulties of conducting monetary           in expected inflation falls on promises    navigating a liquidity trap requires
policy when there is a liquidity trap.        of future policy, but successfully         open communication and transparency
A very weak economy can require               accomplishing this goal may require        because it requires the public to
negative real interest rates, and rates       credibility for temporarily deviating      understand not only current policy but
that are sufficiently negative can be         from the central bank’s long-run           future policy as well. BR
hard to achieve when the short-term           inflation target. Furthermore, that
nominal interest rate is bounded              deviation, if successful, could result
below by zero. Although, in theory,           in the public’s no longer believing in
generating increased expectations of          the long-run target. The central bank


Auerbach, Alan, and Maurice Obstfeld.         Eggertsson, Gauti B., and Michael          Plosser, Charles I. “The Economic Outlook
“The Case for Open Market Purchases in a      Woodford. “The Zero Bound on Interest      and Some Challenges Facing the Federal
Liquidity Trap,” American Economic Review     Rates and Optimal Monetary Policy,”        Reserve,” speech at the 2009 Economic
(March 2005), pp. 110-37.                     Brookings Papers on Economic Activity, 1   Outlook Panel, University of Delaware,
                                              (2003), pp. 139-233.                       January 14, 2009.
Bernanke, Ben S. “Four Questions about
the Financial Crisis,” speech, Morehouse      Goodfriend, Marvin S. “Interest Rate       Svensson, Lars E. O. “The Zero Bound in
College, April 14, 2009.                      Policy and the Inflation Scare Problem:    an Open Economy: A Foolproof Way of
                                              1979-1992,” Federal Reserve Bank of        Escaping from a Liquidity Trap?” Monetary
Dotsey, Michael. “How the Fed Affects         Richmond Economic Quarterly, 79:1          and Economic Studies (Special Edition)
the Economy: A Look at Systematic             (Winter 1993), pp 1-23.                    (February 2001), pp. 277-312
Monetary Policy,” Federal Reserve Bank of
Philadelphia Business Review (First Quarter   Krugman, Paul R. “It’s Baaack: Japan’s     Wolman, Alexander L. “Staggered Price
2004), pp. 6-15.                              Slump and the Return of the Liquidity      Setting and the Zero Bound on Nominal
                                              Trap,” Brookings Papers on Economic        Interest Rates,” Federal Reserve Bank
Dotsey, Michael. “Commitment Versus           Activity, 2 (1998), pp. 137-205.           of Richmond Economic Quarterly, 84:4
Discretion in Monetary Policy,” Federal                                                  (1998), pp. 1-24.
Reserve Bank of Philadelphia Business         Levin, Andrew, David Lopez-Salido,
Review (Fourth Quarter 2008), pp. 1-8.        Edward Nelson, and Tack Yun.
                                              “Limitations on the Effectiveness of
Dotsey, Michael, and Charles I. Plosser.      Forward Guidance at the Zero-Lower
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4-17.                                                                                   Business Review Q2 2010 15

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