How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible

March 1, 2003

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Gauti B. Eggertsson How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible, (USA: International Monetary Fund, 2003) accessed November 21, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

I model deflation, at zero nominal interest rate, in a microfounded general equilibrium model. I show that deflation can be analyzed as a credibility problem if the government has only one policy instrument, money supply carried out by means of open market operations in short-term bonds, and cannot commit to future policies. I propose several policies to solve the credibility problem. They involve printing money or nominal debt and either (1) cutting taxes, (2) buying real assets such as stocks, or (3) purchasing foreign exchange. The government credibly "commits to being irresponsible" by using these policy instruments. It commits to higher money supply in the future so that the private sector expects inflation instead of deflation. This is optimal, since it curbs deflation and increases output by lowering the real rate of return.

Subject: Banking, Central banks, Deflation, Inflation, Inflation targeting, Monetary base, Monetary policy, Money, Open market operations, Prices

Keywords: Deficit spending, Deflation, Deflation bias, Inflation, Inflation bias, Inflation expectation, Inflation targeting, Liquidity traps, Monetary base, Monetary policy, Money supply, Nominal interest rate, Open market operations, Price level, WP, Zero bound on nominal interest rates

Publication Details

Pages:

42
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2003/064
Stock No:

WPIEA0642003
ISBN:

9781451848588
ISSN:

1018-5941

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