Lars E.O. Svensson
CEPR and NBER
First draft: January 2003
This version: December 2003
Journal of Economic Perspectives 17-4 (Fall 2003) 145-166.
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.
JEL Classification: E52, F31, F33, F41
Keywords: Zero bound, nominal interest rates, optimal escape