MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in
an Open Economy:
A Foolproof Wayof Escaping froma Liquidity Trap
Lars E. O. Svensson

The paper examines the transmission mechanism of monetary policy
in an open economy with and without a binding zero bound on
nominal interest rates. In particular, a foolproof way of escaping
from a liquidity trap is suggested, consisting of a price-level target
path, a devaluation of the currency and a temporary exchange ratepeg, which is later abandoned in favor of price-level or inflation
targeting when the price-level target has been reached. This will
jump-start the economy and escape deflation by a real depreciationof the domestic currency, a lower long real interest rate, andincreased inflation expectations. The abandonment of the exchangerate peg and the shift to price-level or inflation targeting will avoid
the risk of overheating. Some conclusions for Japan are included.
Key words: Deflation; Liquidity trap; Nominal interest rates

Stockholm University; CEPR and NBER (Internet home page: www.iies.su.se/leosven/)
A previous version of this paper was presented at Bank of Japan’s Ninth International
Conference, “The Role of Monetary Policy under Low Inflation: Deflationary Shocks
and Their Policy Responses,” held in Tokyo, July 3–4, 2000. I thank my discussants,
Glenn Stevens and Job Swank, and Claes Berg, Ben Bernanke, Peter Bofinger, Guy
Debelle, Stefan Gerlach, Charles Goodhart, Koichi Hamada, Dale Henderson, Takatoshi
Ito, Bennett McCallum, Allan Meltzer, Edward Nelson, Christian Pfister, Georg Rich,John Rogers, Shigenori Shiratsuka, Christopher Sims, Frank Smets, Peter Tinsley,
Michael Woodford, and participants of the NBER Summer Institute for useful discussions and comments; Annika Andreasson and Christina Lönnblad for editorial andsecretarial assistance; and the Department of Economics and the International Finance
Section at Princeton University for its hospitality during my visit 1999–2000. I am solely
responsible for expressed views and any errors.

277

I. Introduction
For several decades, high inflation has been the main threat to monetary stability.
The successful disinflation and resulting low inflation rate in many countries,
together with the problematic situation in Japan, has brought the potential threat ofdeflation and a binding zero bound on nominal interest rates (a liquidity trap) into
focus. The zero bound on the central bank’s instrument rate would seem to prevent
expansionary monetary policy in situations when it would be mostly needed. Many
papers have recently discussed the consequences of the zero bound and a liquidity
trap, how to avoid these and how to escape if trapped, often with specific references
to Japan, where the threat of deflation and a binding zero bound has been a reality
for several years.1
There seems to be considerable agreement on how to avoid the zero bound and aliquidity trap. Many papers recommend an explicit positive symmetric inflation
target (say 2 percent per year). Many central banks already implement such inflation
targets. Another possibility is an upward-sloping price-level target path (say rising at
2 percent per year), although there is as yet no central bank that implements explicit
price-level targeting (with either a flat or an upward-sloping price-level target path).2
Svensson (1999b) also suggests that prudent central banks should prepare a setof emergency measures, to be used at preannounced indications of an immanentliquidity trap. These emergency measures would include unorthodox open-market
operations in long government bonds and corporate bonds, direct lending to theprivate sector, foreign-exchange interventions, and fiscal and monetary cooperation
including a money-financed fiscal expansion involving government expenditurecomplementary to private consumption.
There seems to be less agreement on how to escape from a liquidity trap if alreadytrapped. Krugman (1998) has suggested that the central bank should make acommitment to future monetary expansion and has proposed an inflation target forJapan of 4 percent per year for 15 years. The idea is that this would induce inflation
expectations that would reduce the real interest rate (even if the nominal interest
rate is at the zero bound) and thereby stimulate the economy out of the liquidity
trap. A problem with this suggestion is that a mere announcement of a futuremonetary expansion or an inflation target need not be credible with the private sector
and therefore not affect inflation expectations, in the absence of any commitment
mechanism or any action supporting the announcement. Furthermore, the highinflation target for Japan for 15 years may not be credible, since the Bank of Japan
1. These include Bernanke (1999), Blinder (1999), Bryant (1999), Buiter and Panigirtzoglou (1999), BIS ([1999],
section IV), Clouse, Henderson, Orphanides, Small, and Tinsley (1999), Christiano (1999), Freedman (1999),
Goodfriend (1999), Hetzel (1999), IMF (1999), Ito (1999), Johnson, Small, and Tryon (1999), King (1999),
Krugman (1998, 1999), Lebow (1993), McCallum (1999), McKinnon (1999a, 1999b), Meyer (1999), Meltzer(1999a, 1999b, 1999c, 1999d), Mussa (1999), Okina (1999a, 1999b, 1999c), Orphanides and Wieland (1998,
1999), Posen (1998), Reifschneider and Williams (1999), Smets (2000), Svensson ([1999b], section 5 and appendix B), Ueda (1999, 2000), Uhlig (2000), Wolman (1998, 1999), and Woodford (1999a). An early contribution
is Brunner and Meltzer (1968).
2. An inflation target allows base drift in the price level and makes the latter nonstationary, whereas a price-leveltarget (path) does not allow base drift in the price level but makes it (trend-)stationary. The only real-world
example of explicit price-level targeting is Sweden during part of the 1930s; see Berg and Jonung (1999).

278 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

might be tempted to reduce the inflation target to a more conventional level (say2 percent) once the economy has escaped from the liquidity trap. Posen (1998),
analyzing the economic situation of Japan, suggests a fiscal expansion and a more
moderate inflation target of 3 percent that is reduced to 2 percent after a few
years, but he recommends avoiding a yen depreciation. Meltzer (1999a, 1999d)recommends increasing the monetary base, with reference to a real-balance effect on
aggregate demand and that increased supply of money will affect a number of otherasset prices and interest rates in an expansionary direction, even if short nominalinterest rates are zero, especially depreciating the domestic currency. A problem witha real-balance effect on aggregate demand in a liquidity trap is that if the private
sector is already satiated with liquidity, increasing liquidity is unlikely to affectconsumption.3 Furthermore, in a liquidity trap, short nominal government bonds
and money are (close to) perfect substitutes, and open-market operations increasing
private holdings of money and reducing private holdings of short government bonds
would have little effect. Accordingly, Meltzer recommends open-market operations inother assets than short government bonds, for instance, long government bonds orforeign-currency government bonds, to reduce long bond rates and depreciate thedomestic currency, relying on the assumption of imperfect substitutability between
these assets and money/short bonds, but without any discussion of the degree ofimperfect substitutability and how large open-market operations would be needed.
The reason why nominal interest rates cannot fall below zero is that an alternative
to investing in short government bonds is simply to hold cash at zero interest rates.
Buiter and Panigirtzoglou (1999) and Goodfriend (1999) discuss a more exotic wayof eliminating the zero bound by introducing a carry tax, a tax on holding reservesand currency. This would allow negative nominal interest rates in equilibrium, andallow the central bank to achieve the desired stimulating negative interest rate.
Although it seems technically feasible to introduce a carry tax for commercial-bankreserves in the central bank, introducing a carry tax on currency requires technological innovations (electronic chips in the notes, for instance) and also implies
the inconvenience of notes circulating with the same nomination but trading atdifferent discounts.
McCallum (1999) has recommended foreign-exchange interventions to depreciate
the currency and, in this way, stimulate the economy when the interest rate is zero. Hisargument either ignores uncovered interest parity or relies on a portfolio-balance
effect, whereby the relative supply of domestic- and foreign-currency denominatedassets affects the foreign-exchange risk premium and thereby the exchange rate.
Although huge foreign-exchange interventions are likely to affect the exchange rate (ifnot because of a portfolio-balance effect, at least because of the expectations of future
depreciation they may induce), a problem with this argument is that the size of theportfolio-balance effect is controversial and most empirical work on the effect ofsterilized foreign-exchange interventions indicates that the portfolio effect is small or
3. As discussed by Woodford (1999a), Nelson (1999), and McCallum (1999), a direct money effect would enter ifreal balances enter the representative agent’s utility function and this utility function is not additively separable inconsumption and real balances but has a positive cross-derivative. However, reasonable parameter values make any
such effect so small that it can safely be disregarded, also outside a liquidity trap.

279

even negligible. McCallum does not provide any calculations of the magnitude of theforeign-exchange interventions that would be needed to significantly depreciate the yen.
Bernanke (1999), analyzing the situation in Japan, discusses several potential
remedies, especially a relatively high inflation target in the 3–4 percent range for anumber of years to undo the “price-level gap” created by several years of zero or
negative inflation, aggressive foreign-exchange interventions to depreciate the yen,and money-financed fiscal transfers.
Svensson (1999b) suggests that all the emergency measures prepared in advance byprudent central banks (see above) should be used, in the hope that some of these would
work. In particular, a temporary exchange-rate peg is discussed ([1999b], section 5.3):
Could the central bank peg the exchange rate and this way escape the liquidity
trap? Such pegging would involve a commitment to arbitrarily large nonsterilized
foreign-exchange interventions, buying foreign exchange and selling domestic
currency at the pegged rate. Again, for such pegging to succeed, market expectations of future appreciation would have to change. If they do not change, hugeforeign-exchange interventions could be absorbed by the foreign-exchange
market. The question is then, in such a game of attrition, who will blink first, themarket or the central bank? Compared to the usual speculative attack on a pegged
exchange rate to force a devaluation, the central bank does not risk running out of
foreign-exchange reserves; instead it just has to create more domestic currency.
The fact that a commitment to a pegged exchange rate is immediately verifiable
and the technical possibility to always create more domestic currency may
make the commitment more credible in the short run than a commitment toan inflation target when interest rates have reached zero. It cannot be excluded
that an exchange-rate peg can serve as a temporary emergency measure, anintermediate step towards fulfilling an inflation target.
Thus, this argument relies on a commitment by the central bank to buy andsell unlimited amounts of foreign exchange at the given pegged exchange rate. In
particular, it does not rely on any portfolio-balance effects; instead, it relies on thechange in private-sector expectations of future exchange rates brought about by thecommitment to unlimited interventions at the pegged exchange rate. This paper
expands on this idea and argues that there is indeed a safe and foolproof way ofescaping from a liquidity trap in an open economy, namely, (1) announcing an
upward-sloping price-level target path (that is, corresponding to a positive long-run
inflation target) above the current price level; (2) announcing that (a) the currency
will be devalued and the exchange rate pegged at a level corresponding to a realdepreciation relative to a steady-state level, and (b) the peg will be abandoned infavor of price-level targeting (or inflation targeting) once the price-level target pathhas been reached; and (3) just doing it.4
It is argued that this will jump-start the economy by (1) a real depreciation of
the domestic currency relative to a long-run equilibrium level; (2) a lower long real
4. Dale Hendersen, in an intervention from the floor at the conference “Monetary Policy in a Low Inflation
Environment,” October 1999, similarly suggested a temporary peg of the yen and that such a peg would be credible.

280 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

interest rate (since there must eventually be a real appreciation of the domestic
currency, and expected real appreciation of the currency is associated with relatively
low short and long domestic real interest rates); and (3) increased inflation expectations (since, with the exchange-rate peg, expected real appreciation is associated withexpected domestic inflation). The output gap will increase because of (1) and (2),and deflation will turn into inflation because of (1), (3), and the increased output
gap. The economy will find itself out of the liquidity trap (a credible peg will be
associated with a positive short nominal interest rate). The price level will rise andeventually reach the price-level target path, after which the peg will be abandoned.
The proposal acknowledges the crucial role of private-sector inflation expectations
and includes a concrete way for the central bank of affecting those expectations. It
handles the credibility problem associated with Krugman’s proposal, in that it specifies what the central bank should do and not just what it should say, and by giving
the central bank an arena, the foreign-exchange market, where it can quickly demonstrate its resolve to the market by success in pegging the exchange rate. In particular,a price-level target path is a more precise way of undoing the “price-level gap” causedby several years of zero or negative inflation than the high inflation target suggested
by Krugman (1998) and Bernanke (1999). The price-level target path allows inflation to be higher first and lower later, thereby providing an “anchored expansion,”
indeed better anchored than the variable inflation target suggested by Posen (1998).
By including the price-level target path, the proposal makes the temporary peg
consistent with desirable long-run inflation expectations. It differs from McKinnon’s(1999a, 1999b) proposal of a bilateral agreement between the United States andJapan to stabilize the yen/U.S. dollar exchange rate, by the initial real depreciationand the temporary use of the peg (and by being unilateral). The proposal is consistent with Meltzer’s (1999d) and McCallum’s (1999) proposals to depreciate
the currency, but it does not rely on the somewhat controversial magnitude of aportfolio-balance effect. Instead, it relies on affecting exchange-rate expectations
via a commitment to the exchange-rate peg, regardless of the magnitude of any
portfolio-balance effect; in case there is no portfolio-balance effect, it is consistent
with uncovered interest parity.5 Furthermore, in contrast to these proposals, my proposal provides a precise framework, the peg, for the depreciation, and for abandoning
the peg in favor of the long-run inflation or price-level target. Indeed, it appears to bea foolproof way for an open economy in general, and Japan in particular, of escaping
from a liquidity trap.
Chapter II discusses the transmission mechanism of monetary policy in an open
economy, with and without the zero bound, as a background to the proposal.
Chapter III presents the foolproof way of escaping from a liquidity trap in somedetail. Chapter IV contains some conclusions for Japan. The appendix contains sometechnical details.
5. Thus, no portfolio-balance effect is assumed in the model used below. However, as discussed in Appendix 2, one
interpretation of the equilibrium resulting from the temporary peg is that the corresponding commitment tounlimited foreign exchange interventions poses a threat of huge interventions in support of the peg. At such hugeinterventions, a portfolio-balance effect would realistically appear and affect the exchange rate. This threat thenaffects exchange-rate expectations and supports the temporary peg, and a portfolio-balance effect need not be
observed at the moderate interventions that occur in equilibrium.

281

II. The Transmission Mechanism in an Open Economy
In order to discuss the effect of monetary policy actions when the zero bound isbinding, we need to specify the transmission mechanism of monetary policy in general,
and with the zero bound in particular. Several similar models of monetary policy in an
open economy have been presented.6 Here, I use a simplified variant of a model derived
and discussed in detail in Svensson (2000b) and ([1998], appendix).7 The main
characteristics of the transmission mechanism in this and similar models are as follows:(1) Domestic inflation (increases in the general price level of domestically
produced goods and services) depends positively on expected future domestic
inflation (the inflation-expectations channel to domestic inflation) andmarginal cost of the production. Marginal cost, in turn, depends positively on
the output gap (the aggregate-demand channel to domestic inflation) and theexchange rate (via imported intermediate inputs; the exchange-rate channel todomestic inflation).
(2) Consumer price index (CPI) inflation depends positively on domestic inflation and inflation in imported final goods and services. The latter depends
positively on the rate of domestic-currency depreciation (the direct exchangerate channel to CPI inflation).
(3) The output gap (the difference between output and potential output)
depends, via domestic aggregate demand, negatively on the long real interest
rate (the real-interest rate channel to aggregate demand) and, via the relative
price between domestic and foreign goods, positively on the real exchange rate(the exchange-rate channel to aggregate demand).
(4) The long real interest rate depends positively on expected future short nominal rates (the central bank’s instrument rate) and negatively on expected future
domestic inflation.
The main property used in the development of the foolproof way of escaping
from a liquidity trap in Chapter III is that, everything else equal, the output gap
increases from (1) a real depreciation of the domestic currency and (2) a reduction in
the long real interest rate. Domestic inflation increases from an increase in the output
gap, (1), and (3) an increase in private-sector expectations of future domestic
inflation. Thus, any open-economy model with the above rather uncontroversial
characteristics will do.
The model of Svensson (2000b) also introduces somewhat realistic relative lags in
the effects of monetary-policy actions on output and inflation as well as additional
inertia in these variables. These lags imply that expectations play an even more
important role: current domestic inflation and output are predetermined, and only
future domestic inflation and output can be affected by monetary-policy actions.
Furthermore, it is not the current real exchange rate and current long real rate but the
6. See Batini and Haldane (1999), Benigno (1999), Galí and Monacelli (1999), Leitemo (1999), McCallum and
Nelson (1999), Obstfeld and Rogoff (1999), Svensson (2000b), and Weerapana (1998).
7. The model differs from that in Svensson (2000b) and ([1998], appendix) in that the nominal variables and someof the real variables are not measured only as deviations from a steady-state or trend level and in that the zerobound is made explicit.

282 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

expected future real exchange rate and the expected future real interest rate that are ofimportance for private-sector decisions.
The model above does not explicitly model a credit channel (see, for instance,
Bernanke, Gertler, and Gilchrist [1998]) and the more controversial transmission
channels involving direct aggregate-demand effects of money (see Meltzer [1999d],
Woodford [1999a], and Nelson [1999]), the effect of foreign-exchange interventions
on the foreign-exchange risk premium (see McCallum [1999]), and the price-gap or
real-money-gap effects on inflation in P* models (see Hallman, Porter, and Small[1991], Tödter and Reimers [1994], Svensson [2000a], and Gerlach and Svensson[1999]). Indeed, the foolproof way of escaping a liquidity trap presented in Chapter
III does not depend on the presence (or the absence) of those transmission channels.8
Readers not interested in the more detailed description of the model anddiscussion of the transmission mechanism may prefer to skim the next few
subsections or even jump directly to Chapter III.
A. An Illustrative Model of an Open Economy
The model has an aggregate-supply equation (Phillips curve) of the form

πt +1 = α π πt + (1 – α π )πt +2|t + αy yt +1|t + αq (qt +1|t – q) + εt +1 .

(1)Here, for any variable x, x t +τ |t denotes Et x t+τ , that is, the rational expectation of x t +τ inperiod t + τ , conditional on the information available in period t. Furthermore,πt ≡ pt – pt –1(2)

denotes (log) domestic inflation in period t, where pt is the (log) prices of domestic(ally produced) goods. The variable yt is the output gap, defined as
yt ≡ y td – y tn ,(3)

where y td is (log) aggregate demand (output) and y tn is (log) potential output (for simplicity, both are measured as deviations from a constant steady-state level, although
the model could also be formulated in terms of deviations from a steady-state trend).
Potential output is assumed to be exogenous and stochastic and follows
y nt+1 = γ yn y nt + ηnt+1 ,(4)

where the coefficient γ yn fulfills 0 ≤ γ yn < 1 and ηnt+1 is a serially uncorrelated zeromean shock to potential output (a “productivity” shock). The variable qt is the (log)real exchange rate, defined as
q t ≡ st + p *t – pt ,(5)

8. Except possibly, as discussed in Appendix 2, that the temporary peg is supported by a threat of huge foreignexchange interventions that do not materialize in equilibrium but would affect the foreign-exchange risk premiumand depreciate the domestic currency if they were to materialize.

283

where p*t denotes the (log) foreign price level, st denotes the (log) exchange rate
(in units of domestic currency per unit of foreign currency), and q is the steadystate level of the real exchange rate.9 Finally, εt +1 is a serially uncorrelated zero-mean“cost-push” shock. Thus, we have two distinct “supply” shocks, namely a productivity
shock and a cost-push shock. The coefficients α π , αy , and αq are constant andpositive; furthermore, α π is smaller than unity.
This supply function is derived in Svensson ([1998], appendix) (along the lines ofRotemberg and Woodford [1997]), from the first-order condition of an optimization
problem and hence, with some microfoundations. Inflation depends on lagged inflation and previous expectations of the output gap and future inflation. It is similar toa Calvo-type (1983) Phillips curve in that inflation depends upon expectations of
future inflation. It is similar to the Fuhrer and Moore (1995) Phillips curve in that
inflation depends on both lagged inflation and expected future inflation (see also
Estrella and Fuhrer [1998]). Domestic inflation is assumed to be predetermined one
period.10 The term including qt +1|t in equation (1) represents the effect of expected
costs of imported intermediate inputs (or resulting wage compensation).
Let ω be the share of imported goods in the CPI.11 Then CPI inflation, π tc ,fulfills12

π tc = (1 – ω )πt + ωπ tf = πt + ω (qt – qt –1).

(6)

Here, π tf denotes domestic-currency inflation of imported foreign goods, which
fulfills

π tf ≡ p tf – p tf–1 ≡ π *t + st – st –1 = πt + qt – qt –1 ,where
p tf ≡ p*t + st

(7)

is the (log) domestic-currency price of imported foreign goods, andπ *t ≡ p*t – p*t –1(8)

is foreign inflation. That is, for simplicity, I assume that there is no lag in the
pass-through of import costs to domestic prices of imported goods.13
9. Since there are no nontraded goods, the real exchange rate also constitutes the terms of trade.
10. In Svensson (2000b), domestic inflation is assumed to be predetermined two periods in advance, in order to havea two-period lag in the effect of monetary policy on domestic inflation (and hence, a longer lag than for the
output gap, see below).
11. The share of imported goods in the CPI is approximately constant for small deviations around a steady state. It is
exactly constant if the utility function over domestic and imported goods has a constant elasticity of substitution
equal to unity (that is, is a Cobb-Douglas utility function), as is actually assumed in Svensson (2000b).
12. Since there is no interest-rate component in the CPI, it is best interpreted as CPIX; that is, CPI inflation (anddomestic inflation) are exclusive of any credit service costs.
13. There are obviously more realistic and less simplistic ways of modeling the pass-through of exchange-rate
movements to domestic prices of imported final goods.

284 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

Aggregate demand for domestically produced goods is given by the aggregatedemand equation (expressed in terms of the output gap, equation [3]),yt +1 = βy y t – βρ ρt +1|t + β *y y *t +1|t + βq (qt +1|t – q) – (γ yn – βy )y nt + ηdt+1 – ηnt+1 , (9)where y *t is (log) foreign output (measured as a deviation from a constant steady-statelevel), all coefficients are constant and non-negative, 0 ≤ βy < 1, and ηdt +1 is a serially
uncorrelated zero-mean “demand” shock. The variable ρt is defined as∞ρt ≡ ∑(rt +τ |t – r),
(10)
τ =0

where rt , the (short domestic-good) real interest rate, fulfills
rt ≡ i t – πt +1|t ,(11)

where i t is the (short) nominal interest rate. The constant steady-state level of the realinterest rate is denoted r > 0. The zero bound on the nominal interest rate implies
that it fulfills
i t ≥ 0.

(12)

The nominal interest rate is (normally) the instrument of the central bank.14
Thus, the variable ρt is the sum of current and expected future deviations of thereal interest rates from the steady-state level of the real rate. The sum enters in theaggregate demand, since the latter is the forward solution of an Euler condition
involving the short real interest rate, cf. Svensson (1998). The sum always converges
in the equilibria examined below. The variable ρt is (under the expectations hypothesis) related to the deviations from the steady-state level of a long real zero-couponbond rate: consider the real rate r Tt with maturity T . Under the expectations
hypothesis, it fulfillsT

1 r .
r Tt = ––∑ t +τ |tT τ =0Hence, for a long (but finite) maturity T, the variable ρt is approximately the
product of the deviation from the steady-state level of a long real rate and its maturity,ρt ≈ T (r Tt – r).

(13)

The aggregate demand is predetermined one period in advance. It depends onlagged expectations of accumulated future real interest rates, foreign output, and thereal exchange rate. The aggregate-demand equation is derived, from a first-ordercondition consistent with optimization and hence with some microfoundations, and
14. The variable ρt fulfills ρt = ∑∞τ=0r tc+ τ |t – ωqt – r , where r tc ≡ it – π tc +1|t = rt – ω (qt +1|t – qt ) is the CPI real interest rate.
Hence, we can express ρt in terms of r tc rather than rt (the derivation in Svensson [{1998}, appendix] actually
starts from an Euler condition in terms of r tc ).

285

discussed in further detail in Svensson ([1998], appendix). A crucial assumption is thatthe output gap, the current account, and the real exchange rate are all stationary.15,16
The exchange rate fulfills the interest parity conditioni t – i*t = st +1|t – st + ϕt ,(14)

where i *t is the foreign nominal interest rate and ϕt is the foreign-exchange risk
premium. The foreign-exchange risk premium incorporates any exogenous residual
disturbances to the exchange rate, including changes in portfolio preferences, credibility effects, etc. In order to eliminate the potentially non-stationary exchange rate,
I use equation (5) to rewrite this as the real interest parity condition in terms of thestationary real exchange rate,17
qt +1|t = qt + (i t – πt +1|t ) – (i*t – π *t +1|t ) – ϕt .

(15)

Note that qt and ρt are closely related. Solving q t forward and exploiting that qT
approaches q when T → ∞, we have∞∞∞q t – q = –∑(rt +τ |t – r) + ∑(r t*+τ |t – r *) + ∑(ϕ t +τ |t – ϕ )
τ =0

τ =0

τ =0

1 –( ϕ – ϕ ),≡ –( ρt – ρ*t ) + –––––
t
1 – γϕ(16)

where the r *t ≡ i*t – π *t +1|t is the foreign real interest rate, r * is the foreign steady-state
real interest rate, ρ*t is defined in analogy with equation (10), and I use equation (20)below as well as the fact that the steady-state domestic and foreign real interest rate
will be related to the steady-state foreign-exchange risk premium, ϕ , according tor – r* = ϕ.

(17)

Thus, the real exchange rate is related to the negative difference between thedomestic and foreign expected future deviations of the real interest rate from thesteady-state real interest rate.
For simplicity, I assume that foreign inflation, foreign output, and the foreignexchange risk premium follow stationary univariate AR(1) processes,

π *t +1 = π * + γ *π (π *t – π *) + ε *t +1(18)y *t +1 = γ *y y*t + η*t +1(19)

15. There is an obvious similarity to the closed-economy aggregate demand function of Fuhrer and Moore (1995),
except that a lagged long real coupon-bond rate enters in their function.
16. The natural output level enters in equation (9), because the equation is first derived for the level of aggregate
demand. It is then expressed in terms of the output gap by subtraction of the natural output level.
17. Equation (15) may give the impression that the real exchange rate will have a unit root. This is not the case inequilibrium, however. All real variables, inflation rates and interest rates are then stationary. The nominal pricelevel and exchange rate are nonstationary under inflation targeting with base-drift in the price level.

286 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

ϕ t +1 = ϕ + γϕ (ϕ t – ϕ ) + ξϕ ,t +1 ,(20)

where the coefficients are non-negative and less than unity, the shocks are serially
uncorrelated and zero-mean, and π * and ϕ are the constant steady-state levels of
foreign inflation and the foreign-exchange risk premium, respectively. Furthermore,
for simplicity, I assume that the foreign interest rate follows a Taylor-type instrument
rule; that is, it is a linear function of foreign inflation and output,
i *t = i * + f *π (π *t – π *) + f *y y*t + ξ*it ,(21)

where i * ≡ r * + π * (where r * is the constant steady-state foreign real interest rate) is
a constant steady-state level of the foreign interest rate, the coefficients are constantand positive, and ξ*it is a serially uncorrelated zero-mean shock. These specificationsof the exogenous variables are chosen for simplicity; obviously the exogenous
variables may be cross-correlated in more general ways without causing any difficulties, and additional variables can be introduced to represent the state of the restof the world.18
Fiscal policy is not explicitly represented. It is implicitly assumed to be“Ricardian,” so that the government’s intertemporal budget constraint is an identity
and the Fiscal Theory of the Price Level does not apply.
B. The Loss Function, State-Space Form, and Equilibrium
A possible loss function corresponds to “flexible (domestic) inflation targeting” with aconstant inflation target π̂ (thus, stars denote foreign variables and hats denote target
levels). This can be represented as a period loss
L t = (πt – π̂ )2 + λy t2 ,(22)

where λ > 0 is the relative weight on output-gap stabilization, and an intertemporal
loss function∞ τ
Et (1 – δ )∑δ L t +τ ,
(23)
τ =0

where 0 < δ < 1 is a discount factor.19
As shown in Svensson (1998), the model can be written in a convenientstate-space form. Let X t and Yt denote the (column) vectors of predeterminedstate variables and goal variables, respectively, let xt denote the (column) vector of
forward-looking variables, and let vt denote the (column) vector of innovations to
the predetermined state variables,

18. Weerapana (1998) extends this model to a two-country world with endogenous foreign variables.
19. Flexible CPI inflation targeting would have the period loss function L t = (π tc – π̂ )2 + λy 2t. Svensson (2000b) andAoki (1999) compare domestic and CPI inflation targeting from different points of view.

287

X t = (πt , yt , π *t – π *, y*t , i *t – i *, ϕt – ϕ , y nt, qt –1 – q )′Yt = (πt , yt )′xt = (qt – q, ρt – r, πt +1|t )′vt = (εt , ηdt – ηnt, ε *t , η*t , f *π ε *t + f *y η*t + ξ*it , ξϕ t , ηnt, 0)′,where ′ denotes the transpose.20 Then the model can be written[ xX ] = A [ Xx ] + B(i – i ) + [ v0 ]Y = C [ Xx ]t +1
t +1|t

t
t

t

t +1

t

t
t

L t = (Yt – Yˆ )′W (Yt – Yˆ ),

(24)
(25)
(26)

where A, B, and C are matrices or vectors of appropriate dimensions, W is a diagonal
matrix with the diagonal (1, λ), i ≡ r + π̂ is the steady-state level of the nominalinterest rate, and Yˆ ≡ (π̂ , 0)′ is the vector of target levels (see Svensson ([1998],
appendix) for details21).
If the zero bound equation (12) is disregarded, the model is linear with aquadratic loss function. Then, the model is a standard linear stochastic regulator
problem with rational expectations and forward-looking variables.
With forward-looking variables, there is a difference between the case of
discretion and the case of commitment to an optimal rule. In the discretion case, thecentral bank each period minimizes the intertemporal loss function under discretion.
Then, the forward-looking variables will, in equilibrium, be linear functions of thepredetermined variables,
x t = HX t ,(27)

where the matrix H is endogenously determined. The equilibrium reaction function
will be a linear function of the predetermined variables,–
i t = i + f (X t – X ),(28)–
where the row vector f is endogenously determined and X ≡ (π̂ ,0,0,0,0,0,0,0)′
denotes the steady-state levels of the predetermined variables.22
The dynamics of the economy are then described by

20. Intuitively, predetermined variables are determined by lagged variables and current exogenous shocks, whereas
forward-looking variables (non-predetermined variables) are also affected by expectations of future forwardlooking variables. More rigorously, predetermined and forward-looking variables have one-period-ahead
prediction errors that are exogenous and endogenous, respectively.
21. As mentioned above, the variant of the model presented here differs in that domestic inflation is predetermined one
period ahead rather than two and that the steady-state levels of some of the variables are not set equal to zero.
22. In the commitment case, the optimal policy and the forward-looking variables also depend on the shadow pricesof the forward-looking variables. Only the discretion solution is considered here. See Svensson and Woodford(1999) for the difference between discretion and commitment and its importance for inflation targeting.

288 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap––
X t +1 = X + M11(X t – X ) + vt +1 ,(29)

Yt = (C 1 + C 2H + C i f )X t ,(30)

as well as equations (27) and (28), where the matrix M is given by
M ≡A[ HI 00 ] + B [ f 0 ],(31)

where the matrices

[

]

[ ]

M ≡ M11 M21 , C ≡ C 1
M12 M22
C2(32)

are partitioned according to X t and xt .
When the zero bound is taken into account and binding in some states of theworld, the solution is no longer linear and must be found with nonlinear dynamic
programming. In equilibrium, the forward-looking variables and the instrument will
still be functions of the predetermined variables,
x t = H (X t ),(33)

i t = F (X t ),(34)

but the functions H (⋅) and F (⋅) are no longer linear.
C. The Transmission Channels
In summary, the model consists of the aggregate-supply equation, (1), the CPI
equation, (6), the aggregate-demand equation, (9), the definitions of the sum of
current and expected future real interest rates and the real interest rate, (10) and (11),real interest-rate parity, (15), and the equations for the exogenous variables: foreign
inflation and output, the foreign-exchange risk premium, and the foreign interest
rate, (18)–(21).
Let us temporarily disregard the zero bound equation (12) and examine how thetransmission mechanism of monetary policy is modeled here. The timing and thelags have been selected to provide somewhat realistic relative lags for the transmissionof monetary policy. Consider a fall in the instrument, the short nominal interest ratei t , in period t. Current domestic inflation and the output gap are predetermined.
Domestic inflation in period t + 1 will be sticky, and so are domestic inflation
expectations, πt +1|t . Thus, the short real interest rate, rt , is affected, and falls.23 The
forward-looking variables ρt and qt are affected by the current real interest rate but
also by expected future real interest rates. Thus, the change in the whole expected
23. In Svensson (2000b) and (1998), π t +1|t is predetermined (because domestic inflation is assumed to be predetermined two periods ahead), so i t affects rt one-to-one. In this model, π t +1|t is endogenous, and rt being increasing
in i t is an equilibrium property.

289

future path of the real interest rate matters. Assume that there is some persistence inthe real rate fall, so that also the expected real interest rate in the near future falls.
Then, ρt falls and q t rises unambiguously. That is, the long real rate falls, and there isa real depreciation of the domestic currency. The real depreciation affects current CPI
inflation π tc by equation (6), the direct exchange-rate channel to CPI inflation.
Furthermore, ρt +1|t falls, that is, the expected future long real rate falls, since
expected future real rates fall. This increases the output gap, yt +1, by equation (9), andhence increases aggregate demand (since aggregate demand is the endogenous
component of the output gap). This can be called the real-interest-rate channel toaggregate demand. Furthermore, the expected future real exchange rate, qt +1|t , rises,
which further increases aggregate demand one period ahead, which can be called theexchange-rate channel to aggregate demand.
Having traced the transmission channels to aggregate demand, we can examine
the effect on domestic inflation one period ahead, πt +1, in equation (1). In the Calvomodel with inflation predetermined one period ahead that lies behind equation (1),domestic inflation in period t + 1 is determined by expectations in period t of
inflation in period t + 2 and of marginal cost of production in period t + 1. Marginal
cost is increasing in the output gap and, because imported-intermediate inputs areused in production, also in the real exchange rate. This is the reason yt +1|t and qt +1|tenter in equation (1). Thus, expectations of future increases in the output gap andreal exchange rate from the expected fall in future real rates will lead to a rise indomestic inflation one period ahead. This can be called the aggregate-demand channel
and the exchange-rate channel to domestic inflation (this can be said to constitute a
marginal-cost channel to domestic inflation).
Finally, domestic inflation in period t + 1 also depends on expectations ofdomestic inflation in period t + 2, the term πt +2|t in equation (1). With persistence of
the increase in inflation in period t + 1, inflation expectations for t + 2 rise, whichthen adds to domestic inflation in period t + 1. This is a direct expectations channel todomestic inflation in period t + 2. Naturally, this is not the only expectations channel;
indeed, expectations channels abound in the transmission mechanism. We have seen
above that ρt +1|t and qt +1|t that enter into one-period-ahead aggregate demand inequation (9) are determined by accumulated expected future real interest rate. For agiven future nominal interest rate, higher expected inflation also further decreases the
expected future real rate, and hence, adds to the positive effect on aggregate demand.
Indeed, expectations of future variables are crucial in the transmission mechanism.
Thus, by assumption, there is no lag in the monetary policy effect on CPI
inflation, a one-period lag in the effect on aggregate demand, and a one-period lagin the effect on domestic inflation. Both VAR evidence and practical central-bankexperience indicate that there is a shorter lag for the effect of a monetary-policy
action on CPI inflation than for aggregate demand and domestic inflation.24
1. A credit channel and a direct money channel
The reader may have noticed that two potential transmission channels have not beenmodeled above, namely the credit channel and a separate money channel (for instance,
24. See, for instance, Cushman and Zha (1997).

290 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trapa real-balance channel). A more elaborate model than the one underlying equations(1) and (9) with capital market imperfections would, as discussed in Bernanke andGertler (1995) and Bernanke, Gertler, and Gilchrist (1998), allow some firms’ andconsumers’ borrowing possibilities to depend on their collateral (their balance sheet).
These agents then face marginal borrowing costs exceeding the real interest rate
referred to above, by an “external-finance premium.” A reduction in the real interest
rate would then increase the value of the collateral and thereby allow these agents toborrow at a lower external-finance premium and, in this way, additionally stimulate
aggregate demand beyond the “pure” real interest rate effect discussed above, via a“balance-sheet channel.” As detailed in Bernanke, Gertler, and Gilchrist (1998),
improving balance sheets and increased credit flows may also have significant
feedback and magnification effects; what these authors call the “financial accelerator.”
Since these effects would have the same signs as the “pure” real interest rate effects,
they would, in the present simplified model, appear as larger coefficients on the realinterest rate in equation (9) (although a more elaborate model would also introduce
the initial financial position as an important state variable). Thus, in the present
model, we take the credit channel to be included in the interest-rate channel toaggregate demand.
What about a direct money channel, for instance, a real-balance effect, toaggregate demand, in addition to the real interest-rate channel emphasized above?
Naturally, money lies behind the transmission mechanism outlined below in thesense that central banks use open-market operations, especially repurchase contracts,
to affect the amount of reserves supplied and, in this way, supply whatever reserves
are demanded at the desired level of the instrument rate (an operating target), an
overnight rate or a two-week repurchase rate, say. Given this, nothing is lost if wethink of the instrument rate as the central-bank instrument and consider reserves tobe demand-determined. A direct money channel, however, is something different
than supplying reserves to achieve a particular level of the instrument rate;furthermore it involves broad money rather than the monetary base. Meltzer (1999d)
and Nelson (1999) find some empirical support for a direct effect of real money on
aggregate demand, in addition to the effect via the interest rate. Such an effect might
be expected to show up as real money entering on the right side of equation (9), in
addition to the other variables. However, as Woodford (1999a) emphasizes, to theextent that such an effect is interpreted as a wealth effect, the Euler condition used inderiving an aggregate-demand relation as equation (9) already incorporates any
wealth effects (and, more generally, an intertemporal budget constraint).25 As
discussed by Woodford (1999a), Nelson (1999), and McCallum (1999), a directmoney effect would arise, if real balances entered the representative agent’s utility
function and this utility function was not additively separable in consumption andreal balances but had a positive cross-derivative. However, reasonable parametervalues make any such effect so small that it can safely be disregarded. Meltzer
25. This is due to the fact that the Euler condition that is solved forward to get equation (9) is such that current
consumption depends negatively on the real interest rate and positively on expected future consumption, andthe wealth effect (and generally the impact of the intertemporal budget constraint) enters via expected future
consumption.

291

(1999d) and Nelson (1999) emphasize that a direct effect of money may instead bea proxy for effects of other asset prices and interest rates than the short nominalinterest rate, in particular long bond rates. However, if this is the reason for a directmoney effect, including those asset prices and interest rates explicitly would seem
more satisfactory. In our case, a long rate is already included via the variable ρt , and,among other potential asset prices, at least the exchange rate is already included.
For this reason, I choose not to include a separate direct-money channel to aggregate
demand here.26,27
D. A Binding Zero BoundLet us now consider the transmission mechanism when the zero bound equation (12)is taken into account and sometimes binds. Consider a situation where the zerobound is binding, in the sense that equation (28) implies a negative interest rate.
This could, for instance, be the result of a series of negative demand shocks, which
would call for expansionary monetary policy. If the usual instrument rate hits thezero bound, are there any other expansionary monetary policy actions available, ordoes monetary policy become ineffective and the central bank can only wait for
better times? Several potential actions have been discussed in the literature (see thereferences in Footnote 1).
In the model above, it is ρt and even ρt +1|t that matter, rather than rt . If there are
expectations of the nominal interest rate becoming positive in the future, the central
bank may try to commit (as suggested by Orphanides and Wieland [1999]) to maintaining the nominal interest rate at zero for longer than so far expected by the private
sector. If this commitment is credible, this will shift expectations of future nominal
rates downward and, at unchanged inflation expectations, expected future real
rates downward to the same extent. This will reduce ρt and stimulate the economy,
everything else equal. However, absent any particular commitment mechanism, thecommitment may not be credible and interest rate expectations not much affected.
Another action is further expansion of the monetary base, even when the shortinterest rate has fallen to zero, along the lines of Meltzer (1999c, 1999d). But with azero interest rate, short government bonds would be more or less perfect
substitutes for reserves, so it is not clear that the private sector holding more money
and less short government bonds would have much effect on other asset prices,
including the exchange rate, unless a further expansion of the monetary basesomehow affects inflation and exchange-rate expectations. Meltzer actually suggests
26. Although admittedly, ρt , which is proportional to a long real rate, is determined by the simple expectations
hypothesis in equation (10). This may not do justice to Meltzer and Nelson; they may have in mind risk premia,
a term premium, for instance, that depend on real money via some portfolio-balance effect.
27. The so-called P * model is of a different category (see Hallman, Porter, and Small [1991], Tödter and Reimers[1994], and Svensson [2000a]). Here, the price gap (the current price level less the price level in long-run
equilibrium with an unchanged broad money stock) or, equivalently (with a change of sign), the real money gap(current real broad money less real broad money in a long-run equilibrium) enters into a traditional accelerationist Phillips curve in the place of the output gap. Although there is some empirical support for the P * model(see Hallman, Porter, and Small [1991], Tödter and Reimers [1994], and Gerlach and Svensson [1999]), absent
any microfoundations, this empirical support is difficult to interpret. As shown in Rudebusch and Svensson(1999), the real money gap and the output gap may be highly correlated, in which case the real money gap mayenter as a proxy for the output gap. Therefore, I do not incorporate the P * model here.

292 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

open-market operations in other assets than short government bonds, in order toaffect other asset prices, notably the exchange rate, via imperfect substitutability andportfolio-balance effects.
One possibility is to do open-market operations in longer government bonds and,in this way try, to reduce long nominal and real interest rates (also suggested by Lebow[1993]). If this works, it is either because this action reduces expectations of futurenominal rates (under the expectations hypothesis) or because the relation between longand short rates involves risk premia, for instance, term premia (not included in themodel above), that depend on outstanding stocks of long bonds via a portfolio-balance
effect which can be exploited by the central bank. A third possibility is that suchopen-market operations increase inflation expectations and thus lower ρt .
Naturally, rt and ρt are not the only interest rates in a more elaborate setting, there
is a whole spectrum of rates on corporate bonds and loans which are, in equilibrium,
higher than the government bond rates because of some default risk. Thus, thecentral bank can, in principle, do open-market operations in corporate bonds andeven open a window and lend directly to the private sector and thereby lower these
rates and stimulate the economy. Since buying these bonds and making these loans
means taking on some risk, the central bank is subsidizing this risk, so such actions
have elements of fiscal policy in them. This can also be interpreted as an attempt to
exploit the credit channel, by making some firms less dependent on their balance
sheet to obtain loans and effectively lowering their external-finance premium.
Suppose current and expected future nominal rates cannot be further affected. If
the central bank can increase the real exchange rate, that is, cause a real depreciationof the currency, it can still stimulate aggregate demand and inflation via theexchange-rate channels discussed above. Can the central bank affect the exchange rate
when the nominal interest rate is zero? McCallum (1999) has argued that foreignexchange interventions can still affect the exchange rate, even if interest rates are zero.
If the real exchange rate fulfills the interest-rate parity condition equation (15) withan exogenous foreign-exchange risk premium, ϕ t , as in equation (20), the realexchange rate can only be affected if ρt is affected. If the central bank cannot affectcurrent and expected nominal interest rates and expected inflation, it cannot affect ρtand hence, not qt . However, suppose that the foreign-exchange risk premium ϕ t ispartly endogenous and in the simplest possible case via a portfolio-balance effectaffected by relative holdings domestic- and foreign-currency assets. Then, instead ofequation (20) we might have

ϕ t = ψ (bt – b*t – st ) + ϕ̄ t ,ϕ̄ t = ϕ̄ + γ ϕ (ϕ̄ t – ϕ̄ ) + ξϕ ,t +1 ,where bt and b*t are private (log) holdings of domestic- and foreign-currency
denominated assets (including currency), respectively, ψ is a positive constant, andϕ̄ t is the exogenous component of the foreign-exchange risk premium. Then,foreign-exchange interventions that change the relative holdings of domestic- andforeign-currency denominated assets would affect the nominal and real exchange rate.

293

McCallum does not provide any calibration of the parameters or discuss themagnitude of interventions needed to affect the foreign-exchange risk premium,though. Again, aggressive foreign-exchange interventions might affect exchange-rate
expectations and thus affect the current exchange rate, even in the absence of aportfolio-balance effect.
I have already referred to private-sector expectations and several expectations
channels in the transmission mechanism several times. More specifically, if the central
bank can somehow affect private-sector expectations of future inflation, everythingelse equal it will be reducing expected future real interest rates, reduce current andexpected future real rates, increase (depreciate) the current and expected futureexchange rate, increase actual future output, and increase actual future inflation.
Krugman (1998), who has strongly emphasized the role of expectations in gettingout of a zero-bound situation (a temporary liquidity trap), has stated that the central
bank should “credibly promise to be irresponsible.” In less striking but more precise
words, the central bank should attempt to restore inflation expectations to a soundpositive level, more precisely to its inflation target, π̂ > 0. That is, it should credibly
promise to be responsible and bring the inflation back to its target.
Although any increase in private inflation expectations would be helpful in the
short run, as emphasized by Posen (1998) it is advantageous to anchor inflation
expectations to a suitable inflation target, that is, getting a credible inflation target.
This should help avoid the opposite problem, getting too high and/or unstable inflation expectations, and risking a change to a high, unstable, and uncertain inflation
rate. For Japan, Krugman (1998) has suggested a 4 percent inflation target for
15 years. A more moderate target may be more credible, in the sense of it being moredesirable to keep it unchanged after having escaped from the liquidity trap. For
Japan, Posen (1998) has suggested an initial inflation target of 3 percent, to be
reduced to 2 percent within a few specified years.
An announcement is not likely to be enough, though. Setting up the wholeinflation-targeting framework, with published inflation forecasts, transparent
inflation reports, etc., is a more serious commitment. Acting accordingly, motivating
the interventions, explaining the role of the emergency measures used, etc., is then anatural ingredient in building credibility for the inflation target and getting rid ofdeflationary expectations.
A price-level target (path) corresponding to a positive long-run inflation (say2 percent), may, if it can be made credible, have special advantages. With a credible
price-level target, some deflation would, by itself, increase expected future inflation,and hence reduce real interest rates and cause a real depreciation of the currency,
even if nominal interest rates are unchanged. Furthermore, long-run inflation
expectations would not depend on whether the price-level target will be missed in thenear future.28
28. It is an open question whether, away from the zero bound, inflation targeting or price-level targeting is thepreferred policy. Conventional wisdom has been that price-level targeting would imply more short-term inflation
variability and/or output-gap variability. This conventional wisdom has recently been challenged by Svensson(1999a), Woodford (1999b), Vestin (2000), King (1999), and Batini and Yates (1999), where it is shown thatdifferent forms of price-level targeting may very well reduce short-term inflation and/or output-gap variability.

294 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

Although a number of potential monetary-policy actions have been suggested
for a situation with a liquidity trap and a binding zero bound, there remains considerable uncertainty about how effective they might be, especially when they rely on
portfolio-balance effects of uncertain magnitude. None of them seem to be foolproof
ways of escaping from a liquidity trap. In particular, although a credible positive
inflation target or a credible price-level target path would clearly be very desirable,
and by itself stimulate the economy in a liquidity trap via the expectations channels,
it is not clear how effective actions to establish such credibility would be, at least in
the short run.
Fortunately, for an open economy, there seems to be a foolproof way of escaping
from a liquidity trap.

III. A Foolproof Way of Escaping from a Liquidity Trap
Let us now consider an open economy in the above model in an initial liquidity
trap. The zero bound is binding, so short nominal interest rates are zero. Expected
domestic inflation is negative, so the real interest rate is positive. The economy is inrecession and the current output gap is negative. Expectations and forecasts point tocontinued deflation and a negative output gap for some time ahead. The nominalinterest rate is lower than in the rest of the world so, to the extent uncovered interest
parity holds, the domestic currency is expected to appreciate. Flexible inflation
targeting with a small positive inflation target and some weight on stabilizing output
around potential output calls for a more expansionary monetary policy and a lower
real interest rate, but the central bank is prevented from lowering its instrument rateby the zero bound.
A. The Proposal
I would like to suggest that there is indeed a foolproof way of implementing a more
expansionary monetary policy and escaping from such a liquidity trap. This involves
introducing a price-level target path corresponding to a small positive long-run
inflation target and jump-starting the economy by a devaluation of the currency andtemporary exchange-rate peg. More precisely, according to this proposal a central
bank that wants to escape from the liquidity trap should:(1)Announce an upward-sloping price-level target path {p̂t }∞t =t for the domestic
price level,0p̂t = p̂t + π̂ (t – t 0 ), t ≥ t 0 ,0(35)with the price-level target for the current period t 0 exceeding the current pricelevel,
p̂t > pt ,
0

0

(36)

and with a small positive long-run inflation target (for instance, 2 percent
per year),295

π̂ > 0.
(2a) Announce that the currency will be devalued and that the exchange rate will
be pegged to a crawling exchange-rate target,
st = s¯t , t ≥ t 0 ,(37)

where the exchange-rate target s¯t is given bys¯t = s¯t + (π̂ – π *)(t – t 0 ), t ≥ t 0 .
0(38)That is, the central bank makes a commitment to buy and sell unlimited
amounts of foreign currency at the exchange rate s¯t . The initial exchange-ratetarget after the devaluation, s¯t , is chosen such that there is real depreciation of
the domestic currency relative to the steady state,0

qt ≡ p*t + s¯t – pt > q
0

0

0

0

(39)

(recall that the domestic price level is sticky, so that in the short run, the realexchange rate moves one-to-one with the nominal exchange rate). The
exchange-rate target then corresponds to a nominal depreciation of thedomestic currency at the rate of the difference between the domestic inflation
target and average foreign inflation, π̂ – π *. That is, if π̂ < π *, there is anominal appreciation, and if π̂ = π *, the peg is fixed instead of crawling.
(2b)Announce that, when the price-level target path has been reached, the peg
will be abandoned, either in favor of flexible price-level targeting with thesame target path, that is, with a period loss function given by1
L t = ––[(pt – p̂t )2 + λy t2 ],2(40)

or in favor of flexible inflation-targeting with the same inflation target, thatis, with a period loss function given by equation (22). Which alternative isannounced would be determined by whether a price-level targeting withoutbase drift of the price level or inflation targeting with such base drift ispreferred in the long run.29,30(3) Then, just do it.
29. The central bank may also announce that it wants to shift to targeting the CPI level or inflation rather
than domestic price level or inflation. Escaping from the liquidity trap is more easily discussed in terms of thedomestic price level, though.
30. Flexible price-level targeting without base drift in the price level would correspond to the period loss function(equation [40]) rather than equation (22). With such a loss function, the model can be expressed in the statespace form equation (24)–(26), with the vectors of predetermined variables, target variables, and target levels
defined as X t ≡ (πt , yt , π *t – π *, y*t , i*t – i*, ϕt – ϕ , y nt, qt –1 – q, pt –1 – p̂t –1, p̂t ), Yt ≡ ( pt – p̂t , yt )′ and Yˆt ≡ (0,0)′.
That is, the domestic price level and the price-level target are additional predetermined variables.

296 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

B. Why Would This Work?
Why would this work? The argument proceeds in several steps, to be explained indetail below: (1) It is technically feasible for the central bank to devalue the currency
and peg the exchange rate at a level corresponding to an initial real depreciation of
the domestic currency relative to the steady state. (2) If the central bank demonstrates
that it both can and wants to hold the peg, the peg will be credible. That is, theprivate sector will expect the peg to hold in the future. (3) When the peg is credible,
the central bank has to raise the short nominal interest rate above the zero bound to alevel corresponding to uncovered interest rate parity. Thus, the economy is formallyout of the liquidity trap. In spite of the rise of the nominal interest rate, the long real
rate falls, as we shall see. (4) Since the initial real exchange rate corresponds to a realdepreciation of the domestic currency relative to the steady state, the private sector
must expect a real appreciation eventually. (5) Expected real appreciation of thecurrency implies, by real interest parity equations (15) and (16), that the long realinterest rate is lower. (6) Furthermore, given the particular crawling peg equation(38), a real appreciation of the domestic currency will arise only if domestic inflation
exceeds the inflation target. Therefore, the private sector must expect inflation to
eventually rise and even exceed the inflation target.
(7) The economy is hence jump-started by (a) a real depreciation of the domestic
currency, (b) a lower long real interest rate, and (c) increased inflation expectations.
Via the transmission channels discussed in Chapter II, the output gap will risebecause of (a) and (b). Inflation will increase above the inflation target by (a), (c), andthe increase in the output gap, and thus induce a real appreciation of the domestic
currency. (8) With actual inflation above the inflation target, the price level will
eventually catch up with the price-level target path. (9) When the price-level target
path has been reached, the peg will be abandoned, and monetary policy shifts toflexible price-level targeting or flexible inflation targeting, depending on what has
previously been announced.
Let me explain this argument in more detail. With regard to step (1), it is indeed
possible for the central bank to devalue the domestic currency and peg the nominal
exchange rate at a level corresponding to a real depreciation relative to the steadystate. The central bank will make a commitment to buy and sell unlimited amountsof domestic currency for foreign currency at the target exchange rate. Since thecurrency has been devalued so as to achieve a real depreciation relative to the steadystate, the currency will be strong in the sense of there being appreciation pressure.
Thus, the domestic currency will be in demand, and the central bank can always
fulfill that demand by issuing enough volumes of domestic currency. The central
bank’s foreign-exchange reserves will rise, but this is not a problem in a situation
when the central bank wants inflation and inflation expectations to pick up.
In contrast, a central bank defending a weak currency, in the sense of there being
depreciation pressure, would be buying the domestic currency and paying with its
foreign-exchange reserves, eventually risking running out of foreign-exchange reserves
and having to float the currency. There is indeed a big difference between defending
a strong currency and a weak one, since by issuing more domestic currency andallowing foreign-exchange reserves to grow without bounds, the strong currency can297be defended indefinitely. There are many examples of central banks pegging a weakcurrency being overwhelmed by speculative attacks, and having to float because they
have run out of foreign-exchange reserves or because the level of domestic interest
rates needed to stop the onslaught are too costly to be credible.31 In contrast, a central
bank pegging a strong currency would only abandon the peg by choice, if the size ofthe foreign-exchange reserves and the stock of money become too inflationary or
the low interest rate to counter the appreciation pressure is too expansionary andcauses the economy to overheat. This is obviously not the situation for an economy
in a liquidity trap. When inflation and activity starts picking up, the price-level
will eventually hit the price-level target path, and the peg will be abandoned.
The idea is that the price-level target shall be met before the economy has become
dangerously overheated.
Note that the argument does not depend on any portfolio-balance effects offoreign-exchange interventions, in contrast to the argument of Meltzer (1999d) and
McCallum (1999), and thus, it is more general. Indeed, we can assume that there isno portfolio-balance effect and that uncovered interest parity equation (14) holds,
with an exogenous or even zero foreign-exchange risk premium. As long as thecentral bank supplies an unlimited amount of domestic currency at the target
exchange rate s¯t , arbitrage in the foreign-exchange market will ensure that thisexchange rate is the equilibrium exchange rate.32 Alternatively, as discussed inAppendix 2, one can think of the temporary peg as supported by a threat of foreignexchange interventions of huge volumes, at which a portfolio-balance effect would
realistically appear and depreciate the currency. This threat excludes the possibility
that the peg would fail.
With regard to step (2), if the central bank thus demonstrates that it can hold thepeg, the peg will become credible. That is, private-sector exchange-rate expectations
will fulfill
st +τ |t = s¯t +τ , τ ≥ 0.

(41)

With regard to step (3), combining equation (41) with equation (38), we have thatprivate-sector exchange-rate expectations fulfill
st +1|t = st + π̂ – π *.

(42)

Together with equation (14), this implies that the equilibrium interest rate will nolonger be zero but rise to fulfill

31. See, for instance, Svensson (1994) for more discussion.
32. If there is a portfolio-balance effect and sterilized interventions are effective, the central bank will have a choice
between nonsterilized interventions, which amounts to buying foreign-exchange reserves and paying in domestic
currency; thus see the monetary base rise with the foreign-exchange reserves, or sterilized interventions, whichamount to selling domestic bonds for the foreign-exchange reserves (that is, reducing domestic credit) and keep
the monetary base constant. However, the central bank might run out of domestic credit, in which case it would
have to switch to nonsterilized interventions. Since the central bank always has the option to use nonsterilizedinterventions by issuing more currency, it can always fulfill the demand for the currency.

298 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

i t = i*t + π̂ – π * + ϕt ,(43)

and the zero bound is no longer binding (I assume that i *t + π̂ – π * + ϕt > 0). Thatis, when the peg becomes credible, if the central bank sets the interest rate equal
to equation (43), domestic and foreign investors are indifferent between holding
domestic-currency and foreign-currency denominated short bonds, and the central
bank need no longer intervene on the foreign-exchange market to support theexchange-rate peg. Then, the monetary base will be demand-determined, at theinterest rate given by equation (43). Appendix 1 supplies some further details on theestablishment of the peg.33
At first, we might think that the rise in the nominal interest rate to equation (43)implies that the real interest rate has increased and monetary policy may not necessarily have become more expansionary, when the effects of both the real interest rate
and the real exchange rate are taken into account.34 As we shall see, however,increased inflation expectations dominate the rise in the nominal rate.
Indeed, because the initial real exchange rate corresponds to a real depreciation
relative to the steady state, equation (39), a real appreciation of the domestic currency
must eventually occur, and the private sector must expect it to eventually occur, step(4) above. Furthermore, by equation (16), we see that the real depreciation relative tothe steady state implies a low ρt relative to ρ*t . Thus, we have demonstrated step (5),that the long real interest rate is lower.
With regard to step (6), if the peg holds, by equations (5), (37), and (38), we haveq t +1 – qt = –(πt +1 – π̂ ) + (π *t +1 – π *).

(44)

For simplicity, let me temporarily take foreign inflation to be deterministic andconstant, so thatπ *t +1 ≡ π *(45)(that is, I assume that γ *π = 0 and ε *t ≡ 0 in equation [18]; the more general case withequation [18] and base drift in the foreign price level is discussed in Appendix 3).
Then, we haveq t +1 – qt = –(πt +1 – π̂ ),(46)

so a real appreciation of the domestic currency occurs only if domestic inflation
exceeds the inflation target. When the peg is credible, equation (41), this means thatthe private sector must expect inflation to eventually exceed the inflation target,
33. A rise in short and long nominal interest rates implies capital losses for holders of government bonds andcorresponding gains for the government. If these losses are a problem, they can obviously be undone byadjustment of the coupon on government bonds.
34. Blinder (1999), in his comments at the conference “Monetary Policy in a Low Inflation Environment,” October
1999, in reference to an intervention from the floor by Dale Henderson suggesting a peg of the yen, observes thatthe nominal interest rate would then rise to the level of the foreign interest rate and concludes that the increase in
the interest rate would imply a tightening of monetary policy.

299

πt +τ |t – π̂ = –(qt +τ |t – qt +τ –1|t ) > 0,(47)

for some τ ≥ 1, and step (6) has been demonstrated.
Thus, in step (7), monetary policy is indeed expansionary, and the economy isjump-started by (a) a real depreciation of the domestic currency relative to the steadystate, (b) a lower long real interest rate, and (c) increased inflation expectations.
With regard to step (8), we have already noted that a real appreciation (after the
initial real depreciation) of the domestic currency implies that domestic inflation ishigher than the inflation target. Thus, we know that the price level is approaching
the price-level target path from below. Do we know that the price level will actually
hit the price-level target path in finite time?
Suppose the exchange-rate peg would be maintained forever, and consider
the steady-state domestic price-level path, {p¯t }∞t =t , that is consistent with theexchange-rate peg. It is given by0p¯t ≡ p*t + s¯t – q(48)= p*t + s¯t – q + π̂ (t – t 0 ),
0

(49)

0

where I have used equations (8), (35), (37), and (45). We realize that if thissteady-state price-level path is above the price-level target path,p¯t > p̂t ,(50)

the price-level target will be reached in finite time. Furthermore, from equations (35)and (49), we havep¯t – p̂t = p*t + s¯t – q – p̂t000≡ (qt – q ) – (p̂t – pt ).
000Thus, in order for equation (50) to be fulfilled, we must haveq t – q > p̂t – pt > 0,000where the last inequality restates equation (36).
Thus, the central bank wants the initial devaluation to cause a real depreciation
relative to the steady state that is larger than the difference between the initial
price-level target and the initial price level. The central bank can use the initial
real depreciation relative to the steady-state level, qt – q, as a measure of the extent
to which monetary policy is initially expansionary.35 The difference between the0

35. Letting the real exchange rate in the liquidity trap immediately before the announcement be denoted by qt – , we
can use the difference q t – qt – ≡ st – st – as (one measure of) the change in monetary policy with the new policy,
the boost to the economy.
0

0

0

0

0

300 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

price-level target and the initial price-level, p̂t – pt , will be a measure of how muchthe economy is intended to inflate and expand before the price-level target is hit; thatis, how much of the “price gap” caused by several years of zero or negative inflationthat the central bank intends to undo. For a given initial depreciation relative to thesteady state (q t – q), the price-level target will be hit sooner the smaller the differencep̂t – pt . For a given difference p̂t – pt , the economy will hit the price-level target
sooner and with higher activity and inflation, the larger the initial real depreciation
relative to steady state (qt – q). Clearly, a greater and quicker recovery from theliquidity trap runs the risk of overheating the economy before or as the price-leveltarget is being hit.36
0

0

0

0

0

0

0

0

C. The Roles of the Price-Level Target Path and the Exchange-Rate Peg
The role of the price-level target path is to provide the best nominal anchor for the
economy. Once credible, a price-level target implies that long-run inflation expectations are independent of inflation the first few periods, and even that a few periods ofdeflation increase inflation expectations for the near future, thus providing automatic
stimulation of the economy. Furthermore, the uncertainty about long-run inflation
falls with the horizon. The difference between the initial price-level target from theinitial price level provides a measure of how much accumulated above-normal future
inflation the central bank wants, that is, how much of the price gap it wants to undo.
The price-level target path also provides a well-defined criterion for abandoning thepeg when the latter has done its work.
The role of the devaluation and peg corresponding to a real depreciation relative
to the steady-state level is to jump-start the economy out of the liquidity trap. The
difference between the initial real exchange rate after the devaluation and either
the steady-state level of the exchange rate or the initial real exchange rate before thedevaluation provides a measure of the magnitude of the jump-start, the initial boost
to the economy.
D. The Central Bank’s Balance Sheet
What are the balance-sheet consequences for the central bank of this policy? The
initial devaluation will give the central bank a capital gain on (the domestic-currency
value of ) its initial foreign-exchange reserves. While defending the peg in the initial
phase, the central bank acquires foreign-currency denominated assets with a depreciated domestic currency, at the exchange rate s¯t . The extent to which the central
bank’s foreign-exchange reserves will rise initially depends on how long and how
massive foreign-exchange interventions it takes to gain credibility for the peg. Once
credibility has been achieved and the domestic interest rate has risen to equation (43),the money base will be demand-determined, and the domestic-currency return on
foreign-exchange reserves equals equation (43). Thus, initial capital gain on theforeign-exchange reserves is the main balance-sheet consequence for the central bank.
Appendix 1 provides further details on the initial currency flows.
036. Obviously, the precise path of the economy can be characterized more explicitly, for instance by simulations of
the model.

301

IV. Conclusions for JapanThe monetary policy of the Bank of Japan is very controversial. A number of economists, including Bernanke (1999), Blinder (1999), Ito (1999), Krugman (1998),
McCallum (1999), Meltzer (1999a, 1999b, 1999c, 1999d), Mussa (1999) Posen(1998), and Svensson (1999b) have suggested monetary policy actions and changes
that may improve the economic situation in Japan. In particular, Bernanke,
Krugman, Meltzer, and Posen have contributed more detailed arguments, criticism,and suggestions. In contrast, responses from the Bank, including Okina (1999a,
1999c) and Ueda (1999, 2000), have consistently defended a policy of not taking
any actions beyond lowering the instrument rate to zero.
The gist of the Bank of Japan’s argument, as far as I can see, seems to be that,since one cannot be absolutely sure that any given policy action or change in themonetary policy regime will succeed in getting the economy out of the liquidity trap,
it is safer not to try. The logic of this argument escapes me. Instead, as arguedin Svensson (1999b), it seems that prudent policy calls for trying a number of thesuggested remedies (as long as they are not inconsistent), in the hope that some
may work. Some of the Bank’s arguments for no further action have pointed topotential negative consequences for its balance sheet and stated that the responsibility
for foreign-exchange interventions rests with the Ministry of Finance. This seems
like setting myopic bureaucratic interests and technical details above the welfareof the country, in a situation where leadership and resolve is called for (seeBernanke [1999]).
Now, there is an additional suggestion for the Bank of Japan (and the Ministry of
Finance): a foolproof way of escaping from its liquidity trap and recession, namely
combining a price-level target path corresponding to positive inflation with adevaluation of the yen and a temporary exchange-rate peg to jump-start theeconomy. Exchange-rate policy and monetary policy cannot be separated underfree international capital mobility, since exchange rates and interest rates cannot
then be set independently. Nevertheless, many countries, including Japan, have theinconsistent institutional setup that exchange-rate policy is the responsibility of thegovernment, via the ministry of finance, rather than the responsibility of the central
bank. For Japan, I understand that the Bank is not allowed to undertake independent
foreign-exchange interventions in order to affect the exchange rate. Given this, thetemporary exchange-rate peg required for the foolproof way of escaping a liquidity
trap requires an explicit agreement between the Bank and the Ministry of Finance.
When the welfare of the country is at stake, such an agreement should not bedifficult to conclude.37
37. Since the net balance-sheet consequences for the Bank of Japan of the proposed way of escaping from theliquidity trap seem to be positive, they provide no reason for the Bank’s objections. The Bank of Japan Law has
the asymmetric provision that the Bank’s profits are delivered to the government whereas losses are borne by the
Bank (see Okina [1999a]). Because of this, the Bank has resisted proposals to buy long-term government bonds,
since it would suffer capital losses when long-term bond rates rise to normal levels (even though these losses
would correspond one-for-one to government capital gains). It may be advantageous, as suggested by Bernanke(1999), to revise the law to put the Bank on a fixed operating allowance and make the government the residual
claimant of gains and losses to the Bank’s balance sheet. Before such a revision, it would seem that an agreementwith the Ministry of Finance on how to escape from the liquidity trap could also include a government guarantee

302 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

Given the discussion in Okina (1999a, 1999b, 1999c) and Ueda (1999, 2000),
what objections might the Bank of Japan have to my proposal? The proposal of
Krugman (1998) and others of a positive inflation target has been rejected by the
Bank with the argument that the proposal does not in itself suggest any means for the
Bank to achieve the inflation target. Regardless of the validity of this argument, it
does not apply to my proposal of a price-level target path, since my proposal suggests
a very specific means to achieve the price-level target, namely the temporary
exchange-rate peg. With regard to the proposal by Meltzer (1999d), McCallum(1999) and others to depreciate the yen, Okina (1999a, 1999b, 1999c) emphasizes
that it is the Ministry of Finance and not the Bank that is responsible for exchangerate policy, seems to agree that unlimited foreign-exchange interventions (in cooperation between the Bank and the Ministry of Finance) to achieve a target exchange
rate would work, but warns that “given that the floating exchange rate system has
prevailed among industrialized countries for quite a long time, any attempt atunlimited intervention to bring the foreign exchange rate back to something akinto a fixed exchange rate regime would be a grand experiment” ([1999b], p. 196)
(probably meaning “too grand an experiment”). This argument (again regardless of
its validity) does not seem to apply to my proposal, since that is for a temporary devaluation and exchange-rate peg to achieve the price-level target and not a permanent
shift to a fixed exchange-rate regime (as proposed by McKinnon [1999a, 1999b]).
One possible objection to the proposal is that it is similar to a competitive
devaluation, and that trading partners may have objections. First, one can observe
that, due to equation (16), any monetary expansion that results in a lower longreal interest rate must in equilibrium be associated with a real depreciation. Hence,
if one objects to any real depreciation, one essentially objects to any monetary
expansion. Second, jump-starting the Japanese economy should sooner or later
increase Japanese demand for imports from the rest of the world. As is well known,
the current account effects of a devaluation are generally ambiguous, with substitution and income effects of opposite signs. To most observers, it seems rather
uncontroversial that Japanese, Asian, and world welfare would all be well served by
an expansion of the Japanese economy.38

to cover any capital losses encountered by the Bank. To most observers, it of course seems bizarre if minor
balance-sheet consequences (especially if they cancel between the Bank and the government) are allowed to standin the way of the welfare of the country.
38. At the time of writing, the official view of the Bank of Japan is that the Japanese economy has improved to suchan extent that any further monetary expansion is not needed, and it has just (defying practically all external
advice, including IMF [2000]) taken the very controversial action of raising the interest rate above zero, statingthat “deflationary concern has been dispelled” (Bank of Japan [2000]) without reference to forecasts of the CPI
or GDP deflator and in spite of current deflation in these price indices.

303

APPENDIX 1: DEVALUING THE CURRENCY AND ESTABLISHING
THE PEGThis appendix discusses the establishment of the temporary peg in some detail.
A. Before the Peg
In the initial situation, before the devaluation, we have a zero interest rate (i t = 0), a
clean float, and, by equation (14),st +1|t – st = –i *t < 0,

(A.1)

where I for simplicity set the foreign-exchange risk premium equal to zero (ϕt ≡ 0).
That is, the currency is expected to appreciate at a rate equal to the foreign interest
rate. The foreign-exchange market is in equilibrium and there are no foreignexchange interventions. The expected domestic-currency (one-period) return on
foreign (-currency one-period) bonds equals the zero domestic-currency (one-period)
return on domestic (-currency one-period) bonds. Let t 0– denote the “beginning” ofperiod t 0 , before the (unanticipated) announcement of the devaluation and thepeg, so the initial exchange rate, st – , and exchange rate expectations, st +1|t – , in the
beginning of period t 0 fulfill000

st +1|t – – st – + i*t = 0,
0

0

0

0

hence making the expected one-period domestic-currency return on foreign bonds
equal to zero.
B. Initial Lack of Credibility of the Peg
Let t 0 denote the “middle” of period t 0 , after the announcement of the devaluationand the central bank’s commitment to buy and sell unlimited amounts of foreignexchange at the exchange rate s¯t > st – . Suppose that the peg is not credible. Moreprecisely, suppose that expectations of the period-t 0 + 1 exchange rate remain thesame, so st +1 = st +1|t – . Let the domestic interest rate be held at zero. Then the expected
one-period domestic-currency return on foreign bonds at the exchange rate s¯t fulfills
0

0

0

0

0

0

st +1|t – s¯t + i*t < 0,
0

0

0

0

so the expected one-period domestic-currency return on foreign bonds is less than
the return on domestic bonds. Then there will be excess demand for domestic
currency and excess supply of foreign currency. The central bank then intervenes
and equilibrates the foreign-exchange market at the exchange rate s¯t by supplying thecorresponding amount of domestic currency, thereby adding to its foreign-exchange
reserves. Arbitrage among foreign-exchange traders ensures that the market exchange
rate equals s¯t .
00

304 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

C. A Credible Peg and a Zero Interest Rate
Next, suppose that the peg becomes credible, when the central bank has demonstrated that it can fulfill the excess demand for domestic currency, so exchange rate
expectations fulfill
st +1|t = s¯t +1|t
for t ≥ t 0. Suppose the interest rate is still held at zero. Then the expected one-period
domestic-currency return on foreign bonds in period t 0 is by equation (38) given bys¯t +1|t – s¯t + i*t = π̂ – π * + i*t > 0,
0

0

0

0

0

(where I again assume that π̂ – π * + i *t > 0). Now, the expected domestic-currency
return on foreign bonds has become positive and larger than the zero return on
holding domestic bonds. Then foreign exchange will be in excess demand anddomestic currency will be in excess supply. The central bank will have to intervene in
the opposite direction, buying domestic currency and selling foreign exchange. It will
hence be reducing its foreign-exchange reserves and it will have to raise the domestic
interest rate before its foreign-exchange reserves are extinguished.
D. A Credible Peg and an Equilibrium Interest Rate
So, let the central bank raise the domestic interest rate to equal
i t = π̂ – π * + i *t
for t ≥ t 0 (corresponding to equation [47] with ϕt ≡ 0). Then the expected domesticcurrency returns on domestic and foreign bonds are equal, the foreign-exchange
market is in equilibrium, and no foreign-exchange interventions are needed.
The total demand for base money will, in the simplest case, be a function of anddecreasing in the domestic interest rate and increasing in the volume of transactions
in domestic currency, which we assume depends on the output level. Thus, we
can writeMt–––= g (i t , Y td ),
Pt

(A.2)

where Mt is the quantity of base money, Pt ≡ e p is the absolute domestic price level
and Y td ≡ e y is the level of real domestic output (aggregate demand). More precisely,
the central bank will be reducing the monetary base, via open-market operations or
unsterilized foreign-exchange interventions, so as to increase the interest rate to theequilibrium level. Furthermore, the monetary base will equal the sum of the central
bank’s holding of domestic bonds (domestic credit), Dt , and the domestic-currency
value of its holdings of foreign-currency bonds (foreign-exchange reserves), R t(measured in foreign currency),
t

d
t

305

Mt = Dt + S̄t R t ,where S̄t ≡ e s¯ is the absolute level of the exchange rate peg. Thus, although the total
domestic monetary base, as usual under an exchange rate peg, is given to the central
bank by equation (A.2) in equilibrium, the central bank can affect the compositionof the monetary base into domestic credit and foreign-exchange reserves. For
instance, in the previous stage (Section C)—when the peg is credible, the domestic
interest rate is at zero (below the equilibrium level), the central bank is losing
foreign-exchange reserves—the central bank can time the increase in the interest rate
to the equilibrium level and stop intervening when the foreign-exchange reserves
have fallen to a desirable level.
t

E. Announcing the Peg and Increasing the Interest Rate Simultaneously
Note that the central bank could in principle announce the peg and increase in
the interest rate at the same time. The expected domestic-currency excess return on
foreign bonds would then, at the pegged exchange rate, be given by
st +1|t – s¯t + i*t – i t = st +1|t – s¯t – (π̂ – π *).
0

0

0

0

0

0

0

0

If the peg is not credible, so st +1|t < s¯t +1, the excess return is negative, there will be
excess demand for domestic currency, and the central bank will intervene andincrease its foreign-exchange reserves. At the same time, it will be doing open-market
operations so as to reduce the overall monetary base and increase the interest rate.
When credibility of the peg has been restored, it can stop intervening. How muchforeign-exchange reserves have increased by then depends on how quickly credibilityof the peg is achieved. This may come very quickly, in which case little foreignexchange interventions may be needed. Alternatively, the foreign-exchange reserves
may have risen to a level larger than desirable, for instance, having replaced mostof domestic credit, which will require unwinding of the reserves over time. For thisreason, it may be preferable to follow the sequence (sections B to D) above, and only
increase the domestic interest rate after credibility of the peg has been achieved.
000F. Balance-Sheet Consequences
What are the balance-sheet consequences of the operations above? At the devaluation,
the central bank makes a capital gain on its initial foreign-exchange reserves,(S̄t – St – )R t – > 0. After the devaluation, any foreign-exchange interventions are doneat the pegged exchange rate S̄t , and domestic credit and foreign-exchange reserves
earn the same return. When the temporary peg is later abandoned, the central bankwill make capital gains and losses if the exchange rate jumps then. The magnitude of
the capital gains and losses are then affected by the volume of foreign-exchange
reserves, which is under control by the central bank.
00

0

G. An Implicit Short-Run Flow Model of the Foreign-Exchange Market
Note that the discussion in sections A to E above is consistent with an implicit
short-term flow model of the foreign-exchange market, where the volume of

306 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

foreign-exchange intervention (the capital flow) is proportional to the expected excess
return on holding foreign-currency bonds,
st +1|t – st + i *t – i t = –ϕtϕt = ψt (R t – R t –1) + ϕ̄t ,where ϕt is the total foreign-exchange risk premium, the coefficient ψt is positive andits dependence on t allows it to depend on the state of the economy (X t ), and ϕ̄t is
an exogenous component of the total foreign-exchange risk premium.

APPENDIX 2: THE THREAT OF HUGE FOREIGN-EXCHANGE
INTERVENTIONS39
Arguably, the temporary peg could fail in the following way. The central bankannounces the peg and commits to buying and selling unlimited amounts of foreign
currency at the pegged rate, s¯t . However, assume that there is in fact a large but finite
upper limit to how much domestic currency the central bank is willing to issue, andthat this is anticipated by the market. Then, one possible equilibrium would seem tobe that the foreign-exchange market just absorbs the increased supply of domestic
currency up to the central bank’s limit, after which the central bank abandons theattempt to defend the peg. The domestic currency never depreciates to the desiredpeg and continues to float after the defense of the peg is abandoned. If domestic
currency is a perfect substitute for foreign(-currency denominated) assets, theexchange rate would even follow exactly the same path, corresponding to equation(A.1), as followed if the central bank had never attempted to institute the peg. The
foreign-exchange traders who bought the domestic currency at the pegged pricehave made a good deal (and the central bank has suffered a corresponding loss), butotherwise nothing has changed (obviously I am disregarding the fiscal consequencesof the central bank’s loss and the wealth effects of the traders’ gains).
If the limit is small, the above is of course the likely scenario. However, if the limit
is very large, it is realistic at such volumes of currency issue that domestic currency
would no longer be a perfect substitute for foreign assets and some portfolio-balance
effect would appear and depreciate the domestic currency, in which case the investors
who just bought domestic currency would suffer losses. This would seem sufficient to
exclude the equilibrium where the peg fails because the large issue of domestic
currency is just absorbed by the foreign-exchange market with no effect on
the exchange rate. Given this, the threat and any portfolio-balance effects need
never materialize, and uncovered interest parity holds in the equilibrium with thetemporary peg.

39. I have benefited from comments by Michael Woodford on this issue.

307

APPENDIX 3: BASE DRIFT IN THE FOREIGN PRICE LEVEL

Now, I allow π *t +1 to be determined by equation (18) instead of equation (45), so thatp*t , given by equation (8), will no longer be deterministic but include a unit root, andhence be integrated order one, I (1). In particular, it follows from equations (8) and(18) thatt–t
1 – (γ *π )t – t–
p*t = p*t + π *(t – t 0 ) + –––––––––––
γ *π (π *t – π *) + ∑(γ *π )τ ε *t +τ .
1 – γ *π
τ =1
0

0

0

0

(A.3)

Suppose that the central bank pursues the same foolproof policy (1)–(3) with thesame price-level target, equation (35), and the same peg, equations (37) and (38).
Then, equation (44) implies
q t +1 – qt = –(πt +1 – π̂ ) + (π *t +1 – π *),instead of equation (46). Thus, now
q t +τ |t – qt +τ –1|t = –(πt +τ |t – π̂ ) + (γ *π )τ (π *t – π *).
If the term (γ *π )τ (π *t – π *) is sufficiently small, expected real appreciation would still
approximately mean expected domestic inflation above the inflation target.
The domestic price level consistent with the peg and the steady-state level of thereal exchange rate, equation (48), is now
t–t
1 – (γ *π )t – t–p¯t = p*t + s¯t – q + π̂ (t – t 0 ) + –––––––––––
γ *π (π *t – π *) + ∑(γ *π )τ ε *t +τ ,1 – γ *π
τ =1
0

0

0

0

0

instead of equation (49). This will introduce the same base drift in p¯t and pt as in p*t ,which will introduce more variability in the time required for the domestic price levelto catch up with the price-level target path. Unless foreign inflation is far off its
steady-state level or the shocks to foreign inflation are large, if the catch-up would
occur fairly soon in the absence of foreign price-level drift, this base drift will notmatter much.
We note that p¯t expected in period t 0 , p¯t |t , fulfills0

1 – (γ *π )t – t–p¯t |t – p̂t = (qt – q) – (p̂t – pt ) + –––––––––––
γ *π (π *t – π *).
1 – γ *π
0

0

0

0

0

0

Thus, to ensure that p¯t +T |t > p̂T for some horizon T > 0, the initial devaluation
should be adjusted to fulfill00

1 – (γ *π )T
q t – q > p̂t – pt – ––––––––––
γ *π (π *t – π *) > 0.
1 – γ *π
0

0

0

0

308 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

That is, the initial devaluation should take into account the expected foreign
price-level increase in excess of that corresponding to average foreign inflation. This
excess foreign price-level increase is measured by the term
1 – (γ *π )T––––––––––
γ *π (π *t – π *).
1 – γ *π0Note that there is a more sophisticated crawling (and drifting) peg thatcompensates for the base drift in the foreign price level. This would instead ofequation (38) bes¯t = s¯t + π̂ (t – t 0 ) – p*t .
0With p*t given by equation (A.3), this implies
t–t
1 – (γ *π )t – t–s¯t = s¯t + (π̂ – π *)(t – t 0 ) + –––––––––––
γ *π (π *t – π *) + ∑(γ *π )τ ε *t +τ . (A.4)
1 – γ *π
τ =1
0

0

0

0

Thus, this crawling and drifting peg differs from the crawling peg equation (38) by
the last two terms in equation (A.4). With this peg, we would again have equations(46), (47), and (49), and no drift is introduced into p¯t and pt during the peg.

APPENDIX 4: STICKY INITIAL DEFLATION

I assume that the economy is initially in a liquidity trap with deflation, πt < 0. Given
the dependence of inflation on lagged inflation in equation (1), the deflation is
sticky, and even if the temporary peg immediately becomes credible, and the economy is jump-started, deflation may continue for a few periods. Furthermore, it may
take a few additional periods before inflation is above the long-run inflation target, π̂ .
During those periods, by equation (46), the real exchange rate is depreciating further,increasing the expansionary effect of the real exchange rate on the output gap inequation (9) and inflation in equation (1). While there is deflation and expected
deflation, because the nominal interest rate has been increased from zero to equation(47), the short real interest rate will be higher in the first few periods. This mightseem to be contractionary. However, the aggregate-demand relation (derived from aforward-looking first-order condition in Svensson ([1998], appendix) implies that itis the long real interest rate, corresponding to ρt , that matters for aggregate demand.
This long-real interest rate depends on the degree of real depreciation relative to along-run equilibrium, equation (16). Thus, a few periods of deflation and further
real depreciation lowers the long real interest rate further. Even though the first few
periods’ short real interest rates increase, future real interest rates decrease more due
to increased inflation, so the net effect on the long real interest rate is a decrease.
0309

References

Aoki, Kosuke, “Optimal Monetary Policy Responses to Relative-Price Changes,” working paper, 1999.
Bank for International Settlements, 69th Annual Report, Basle: Bank for International Settlements,
1999.
Bank of Japan, “Change of the Guideline for Money Market Operations,” press release, August 11,
2000.
Batini, Nicoletta, and Andrew Haldane, “Forward-Looking Rules for Monetary Policy,” in John B.
Taylor, ed. Monetary Policy Rules, Chicago: University of Chicago Press, 1999.
———, and Tony Yates, “Inflation or Price Level Targeting?” working paper, Bank of England, 1999.
Benigno, Pierpaolo, “Optimal Monetary Policy in a Currency Area,” working paper, Princeton:
Princeton University, 1999.
Berg, Claes, and Lars Jonung, “Pioneering Price Level Targeting: The Swedish Experience 1931–1937,”
Journal of Monetary Economics, 43, 1999, pp. 525–551.
Bernanke, Ben S., “Japanese Monetary Policy: A Case of Self-Induced Paralysis?” working paper,
Princeton University, 1999.
———, and Mark Gertler, “Inside the Black Box: The Credit Channel of Monetary Policy
Transmission,” NBER Working Paper No. 5146, National Bureau of Economic Research,
1995, and Journal of Economic Perspectives, 9 (4), 1995, pp. 27–48.
———, ———, and Simon Gilchrist, “The Financial Accelerator in a Quantitative Business Cycle
Framework,” NBER Working Paper No. 6455, National Bureau of Economic Research, 1998.
Blinder, Alan S., “Monetary Policy at the Zero Lower Bound: Balancing the Risks,” presented at theconference “Monetary Policy in a Low Inflation Environment,” organized by the Federal
Reserve Bank of Boston, October 18–20, 1999.
Brunner, Karl, and Allan Meltzer, “Liquidity Traps for Money, Bank Credit, and Interest Rates,”
Journal of Political Economy, 76, 1968, pp. 1–37.
Bryant, Ralph C., “Comments on Marvin Goodfriend, ‘Overcoming the Zero Bound on Interest Rate
Policy,’” presented at the conference “Monetary Policy in a Low Inflation Environment,”
organized by the Federal Reserve Bank of Boston, October 18–20, 1999.
Buiter, Willem H., and Nikolas Panigirtzoglou, “Liquidity Traps: How to Avoid Them and How to
Escape Them,” working paper, Bank of England, 1999.
Calvo, Guillermo, Staggered Prices in a Utility-Maximizing Framework, Journal of Monetary Economics,
12, 1983, pp. 383–398.
Christiano, Lawrence, “Comments on McCallum, ‘Theoretical Analysis Regarding a Zero Lower Boundon Nominal Interest Rates,’” presented at the conference “Monetary Policy in a Low Inflation
Environment,” organized by the Federal Reserve Bank of Boston, October 18–20, 1999.
Clouse, James, Dale Henderson, Athanasios Orphanides, David Small, and Peter Tinsley, “Monetary
Policy When the Nominal Short-Term Interest Rate Is Zero,” working paper, Federal Reserve
Board, 1999.
Cushman, David O., and Tao Zha, “Identifying Monetary Policy in a Small Open Economy under
Flexible Exchange Rates,” Journal of Monetary Economics, 39, 1997, pp. 433–448.
Estrella, Arturo, and Jeffrey Fuhrer, “Dynamic Inconsistencies: Counterfactual Implications of aClass of Rational Expectations Models,” Federal Reserve Bank of Boston Working Paper
No. 98-5, 1998.
Federal Reserve Bank of Kansas City, “New Challenges for Monetary Policy,” symposium organized by
the Federal Reserve Bank of Kansas City, 1999.
Freedman, Charles, “Comments on Marvin Goodfriend, ‘Overcoming the Zero Bound on Interest Rate
Policy,’” presented at the conference “Monetary Policy in a Low Inflation Environment,”
organized by the Federal Reserve Bank of Boston, October 18–20, 1999.
Fuhrer, Jeffrey C., and George R. Moore, “Monetary Policy Trade-Offs and the Correlation between
Nominal Interest Rates and Real Output,” American Economic Review, 85, 1995, pp. 219–239.
Galí, Jordi, and Tommaso Monacelli, “Optimal Monetary Policy and Exchange Rate Volatility in a
Small Open Economy,” working paper, Universitat Pompeu Fabra, Boston College, 1999.

310 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

Gerlach, Stefan, and Lars E.O. Svensson, “Money and Inflation in the Euro Area: A Case for Monetary
Indicators?” working paper, University of Basel, Stockholm University, 1999.
Goodfriend, Marvin, “Overcoming the Zero Bound on Interest Rate Policy,” working paper, 1999.
Hallman, Jeffrey J., Richard D. Porter, and David H. Small, “Is the Price Level Tied to the M2
Monetary Aggregate in the Long Run?” American Economic Review, 81, 1991, pp. 841–858.
Hetzel, Robert L., “Japanese Monetary Policy: A Quantity Theory Perspective,” Federal Reserve Bank ofRichmond Economic Quarterly, 85/1, 1999, pp. 1–25.
International Monetary Fund, “Safeguarding Macroeconomic Stability at Low Inflation,” in World
Economic Outlook: A Survey by the Staff of the International Monetary Fund—October 1999,
Section IV, 1999, pp. 92–126.
———, “IMF Concludes Article IV Consultation with Japan,” Public Information Notice No. 00/64,
August 11, 2000.
Ito, Takatoshi, “Introducing Inflation Targeting in Japan,” Financial Times, October 19, 1999.
Johnson, Karen, David Small, and Ralph Tryon, “Monetary Policy and Price Stability,” International
Finance Discussion Paper No. 641, Board of Governors, 1999.
King, Mervyn A., “Challenges for Monetary Policy: New and Old,” in “New Challenges for Monetary
Policy,” symposium organized by the Federal Reserve Bank of Kansas City, 1999.
Krugman, Paul, “It’s Baaack! Japan’s Slump and the Return of the Liquidity Trap,” Brookings Papers on
Economic Activity, 2, 1998.
———, “Deflationary Spirals,” working paper, 1999.
Lebow, David E., “Monetary Policy at Near Zero Interest Rates,” Working Paper No. 136, Division of
Research and Statistics, Federal Reserve Board, 1993.
Leitemo, Kai, “Inflation Targeting in Small Open Economies,” working paper, Oslo University, 1999.
McCallum, Bennett T., “Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest
Rates,” working paper, Carnegie Mellon University, 1999.
———, and Edward Nelson, “Nominal Income Targeting in an Open-Economy Optimizing Model,”Journal of Monetary Economics, 43, 1999, pp. 553–578.
McKinnon, Ronald I., “Comments on ‘Monetary Policy and Zero Inflation,’” Monetary and Economic
Studies, 17 (3), Institute for Monetary and Economic Studies, Bank of Japan, 1999,
pp. 183–188, 1999a.
———, “Wading in the Yen Trap,” Economist, July 24, 1999, pp. 77–79, 1999b.
Meltzer, Allan H., “Commentary: How Should Monetary Policy Be Conducted in an Era of Price
Stability?” in “New Challenges for Monetary Policy,” symposium organized by the Federal
Reserve Bank of Kansas City, 1999a.
———, “Commentary: What More Can the Bank of Japan Do?” Monetary and Economic Studies, 17(3), Institute for Monetary and Economic Studies, Bank of Japan, 1999, pp. 189–191, 1999b.
———, “A Policy for Japanese Recovery,” working paper, Carnegie Mellon University, 1999c.
———, “The Transmission Process,” presented to the Deutsche Bundesbank Conference on The
Monetary Transmission Process: Recent Developments and Lessons for Europe, March, 1999d.
Meyer, Laurence, “New Challenges for Monetary Policy: The View from Jackson Hole,” speech,
October 12, 1999.
Mussa, Michael L., comments at the conference “Monetary Policy in a Low Inflation Environment,”
organized by the Federal Reserve Bank of Boston, October 18–20, 1999.
Nelson, Edward, “Direct Effects of Base Money on Aggregate Demand: Theory and Evidence,” working
paper, Bank of England, 1999.
Obstfeld, Maurice, and Kenneth Rogoff, “New Directions for Stochastic Open Economy Models,”
NBER Working Paper No. 7313, National Bureau of Economic Research, 1999.
Okina, Kunio, “Monetary Policy under Zero Inflation—A Response to Criticism and Questions
Regarding Monetary Policy,” Monetary and Economic Studies, 17 (3), Institute for Monetaryand Economic Studies, Bank of Japan, 1999, pp. 157–182, 1999a.
———, “Rejoinder to Comments Made by Professors McKinnon and Meltzer,” Monetary andEconomic Studies, 17 (3), Institute for Monetary and Economic Studies, Bank of Japan, 1999,
pp. 192–197, 1999b.

311

———, “The Risks of Single-Minded Targeting,” Financial Times, November 11, 1999c.
Orphanides, Athanasios, and Volker Wieland, “Price Stability and Monetary Policy Effectiveness When
Nominal Interest Rates Are Bounded at Zero,” working paper, Federal Reserve Board, 1998.
———, and ———, “Efficient Monetary Policy Design near Price Stability,” working paper, Federal
Reserve Board, 1999.
Posen, Adam S., Restoring Japan’s Economic Growth, Washington, D.C.: Institute for International
Economics, 1998.
Reifschneider, David, and John Williams, “Three Lessons for Monetary Policy in a Low Inflation Era,”
FEDS Working Paper No. 1999-44, 1999.
Rotemberg, Julio J., and Michael Woodford, “An Optimization-Based Econometric Framework for the
Evaluation of Monetary Policy,” in NBER Macroeconomics Annual 1997, National Bureau of
Economic Research, 1997, pp. 297–346.
Rudebusch, Glenn D., and Lars E.O. Svensson, “Eurosystem Monetary Targeting: Lessons from U.S.
Data,” CEPR Discussion Paper No. 2522, 1999.
Smets, Frank, “What Horizon for Price Stability?” working paper, European Central Bank, 2000.
Svensson, Lars E. O., “Fixed Exchange Rates as a Means to Price Stability: What Have We Learned?”
EEA Alfred Marshall Lecture, European Economic Review, 38, 1994, pp. 447–468.
———, “Open-Economy Inflation Targeting,” working paper version, Stockholm University, 1998.
———, “Price Level Targeting vs. Inflation Targeting,” Journal of Money, Credit and Banking, 31,
1999a, pp. 277–295.
———, “How Should Monetary Policy Be Conducted in an Era of Price Stability?” in “New
Challenges for Monetary Policy,” symposium organized by the Federal Reserve Bank of Kansas
City, 1999b.
———, “Does the P* Model Provide Any Rationale for Monetary Targeting?” German Economic
Review, 1, 2000a, pp. 69-81.
———, “Open-Economy Inflation Targeting,” Journal of International Economics, 50, 2000b,
pp. 155–183.
———, and Michael Woodford, “Implementing Optimal Policy through Inflation-Forecast
Targeting,” working paper, Stockholm University, Princeton University, 1999.
Taylor, John B., ed. Monetary Policy Rules, Chicago: University of Chicago Press, 1999.
Tödter, Karl-Heinz, and Hans-Eggert Reimers, “P-Star as a Link between Money and Prices inGermany,” Weltwirtschaftliches Archiv, 130, 1994, pp. 273–289.
Ueda, Kazuo, “Japan’s Experience with Zero Interest Rates,” presented at the conference “Monetary
Policy in a Low Inflation Environment,” organized by the Federal Reserve Bank of Boston,
October 18–20, 1999.
———, “Why the Bank of Japan Won’t Target Inflation,” Wall Street Journal, March 6, 2000.
Uhlig, Harald, “Should We Be Afraid of Friedman’s Rule?” working paper, Humboldt University,
2000.
Vestin, David, “Price-Level Targeting versus Inflation Targeting in a Forward-Looking Model,”working paper, Stockholm University, 2000.
Weerapana, Akila, “The Performance of Simple Monetary Policy Rules in a Large Open Economy,”
working paper, Stanford University, 1998.
Wolman, Alexander L., “Staggered Price Setting and the Zero Bound on Nominal Interest Rates,”Federal Reserve Bank of Richmond Economic Quarterly, 84 (4), 1998, pp. 1–24.
———, “Real Implications of the Zero Bound on Nominal Interest Rates,” working paper, Federal
Reserve Bank of Richmond, 1999.
Woodford, Michael, “Price-Level Determination under Interest-Rate Rules,” in Interest and Prices (bookmanuscript), Chapter 2, 1999a.
———, Optimal Monetary Policy Inertia,” NBER Working Paper No. 7261, National Bureau of
Economic Research, 1999b.

312 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Comment

Comment
GLENN STEVENS
Reserve Bank of Australia

It is a remarkable feature of the times in Japan that the notion of the liquidity trap—
a concept originating in the 1930s (though regarded by its creator as not of practicalrelevance to that time)—should be the motivating theme of so many papers in thepast couple of years. Lars Svensson’s paper represents an innovative further step inthis literature.
The recent debate about Japanese monetary policy appears to have gone roughly
as follows. First, short-term interest rates have been pushed down, eventually to zero,as the Bank of Japan (BOJ) fired all the conventional monetary policy bullets in theface of a chronically weak economy suffering the after-effects of the bubble period of
the late 1980s and early 1990s. With the economy remaining weak, a discussion thenensued about whether this was all monetary policy could do, or whether more could
be done. Could monetary policy, by adopting “quantitative” techniques—purchasing
more financial assets and increasing the quantity of reserves in the system—do more
to stimulate the economy?
The answer to this which has been offered by the BOJ has been, as I understand it,that they have already expanded their balance sheet greatly, and that banks already havevery substantial excess reserves at the central bank. Furthering this process simply leads
to even greater excess reserves, but no increase in broader measures of money and credit(and obviously no decline in short-term interest rates) and hence little or no stimulus
to production or prices through the conventional channels. In this view, policy has done
all that can be done, short of some very unorthodox activities indeed.
At this point, the next idea advanced was to announce the pursuit of an inflation
target. Paul Krugman is most prominently associated with this suggestion. Such atarget, if credible, provides a way of increasing inflation expectations and hence
reducing the real interest rate, without the nominal interest rate needing to decline.
The problem pointed out with this idea is that the target cannot be credible unlessthere is a clear way of delivering the inflation being targeted. Short of somemechanical control over prices, the usual way of building credibility is to move somepolicy instrument in a way consistent with the announced intention. By definition,
this is not possible in Japan if the interest rate is the instrument. A further possible
problem is that the targeted inflation rate might have to be fairly high to get the realinterest rate low enough in the short term—a target of 0–2 percent might not be highenough. Hence the idea that the BOJ should “credibly commit to be irresponsible.”Svensson’s paper takes up the debate at this point. He observes, as have McCallumand others, that even if the “orthodox” interest rate channel is exhausted, for an open
economy there is an additional channel through which monetary policy can work: theexchange rate. Furthermore, Svensson argues that use of this channel in a particular
way can give the credibility which seems to be missing in the mere announcement of
an inflation target.

313

Svensson suggests that the central bank in the liquidity trap, and which has seena fall in its price level, should do the following:(1) Announce a price level target, with the target level higher than the current
level, and sloping up over time. Eventually, this becomes a conventional
inflation target, but in the short term potentially allows higher inflation thanthe central bank would like to allow in the long run.
(2) Announce a devaluation of the exchange rate to a level at least as far below thecurrent exchange rate as the target price level is above the current price level,
and then peg the nominal exchange rate at that level.
(3) Intervene in unlimited quantities to hold the nominal exchange rate at thatlevel. The peg is credible because the central bank’s capacity to sell its own
currency is unlimited. For the real exchange rate to return to its (assumed)
initial equilibrium level, domestic inflation must exceed foreign inflation.
The expectation of that future inflation lowers real interest rates andstimulates growth.
No one will disagree with the general idea that one can generate inflation in an
open economy by depreciating. I would also think that a policy goal of trying to
reflate Japan’s price level might find some agreement—though this seemed to beunclear in yesterday’s discussion. In ending inflation, we do not usually insist on
unwinding earlier excesses in the price level, but in ending deflation we would surely
want the price level to recover. The proposal also has the attraction that it outlines
a way, at least in principle, of making sure that a reflation policy is not a “slippery
slope” to permanently high inflation. The importance attached to expectations, key
in Svensson’s paper, is also welcome—though the fact that those expectations are
essentially generated out of the foreign exchange market will make many people
nervous: market notions of long-run equilibrium exchange rates seem to be fairly
weakly anchored, to say the least.
So this sort of proposal would stand a good chance of working well in a small,
open economy. The Swedish experience in the 1930s is often quoted as a precedent
for this approach. But Japan in 2000 is not Sweden in the 1930s. In thinking about
the Japanese case, two questions arise: How open is Japan? And how small is it? In
brief, the answer is “not very” in both cases.
Japan’s trade share of GDP is low by the standards of OECD countries. The sumof exports and imports, as a ratio to GDP, is in fact the lowest in the OECD. Only
the United States and the euro area have trade-to-GDP ratios nearly as low as Japan’s(the individual European nations have quite high trade shares, but much of that tradeis with other euro member countries). So a question mark arises over how effective
exchange rate depreciation would be in practice as a way of generating inflation in
Japan. It would help, but it may take some time for inflation from this source todrive a substantial rise in Japan’s overall price level—or it may take quite a large
depreciation to get it happening quickly.
The second question was how small is the Japanese economy. The answer is that
it is considerably smaller than the United States or the euro area, but much bigger
than any other economy one could name. It is certainly not considered to be a small
economy in global trade. This matters. Genuinely small countries can devalue

314 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Comment

substantially, and outside of a few direct competitor countries, no one minds. If they
notice at all, it would only be because such depreciations have often tended to be
associated with some sort of international liquidity crisis for the country concerned.
Were Japan, on the other hand, to decide to implement Svensson’s suggestion,and set about having a unilateral and substantial depreciation of the yen, we could
expect that other countries would notice, and would care. I would suggest that theUnited States and Europe need to be in agreement with the course in question. Ifthey were not, the new peg could not be fully credible. Would those countries agree?
I leave it to others to speculate, simply observing that pegging the yen is likely tomean, in practice, pegging the U.S. dollar-yen rate. And everything hangs on thecredibility of the peg. If it is not credible, Svensson’s transmission mechanism tends
to break down.
How large a depreciation would we be talking about? Svensson does not say, but
let me give a few pertinent facts. The GDP deflator for Japan fell by about 4 percent
between its peak in 1994 and the March quarter of 2000.40 Suppose we set a pricelevel target that would reverse all this, and then some, so that Japan’s price level istargeted to rise by 10 percent. Svensson’s equation qt – q > p̂t – pt > 0 in his papersays that we need to depreciate the yen by more than 10 percent to achieve this.
Suppose we depreciated it by 20 percent. Then the U.S. dollar-yen rate would be,instead of ¥105, about ¥130.
But remember that the U.S. dollar-yen rate has been as high as that within thepast couple of years. Over the year to September 1998, it averaged ¥133, and it
reached as high as ¥145 at one point. This did coincide with a small, temporary risein the price level, but unless I missed something, that did not transform Japan’s
circumstances. It did not break the expectation of modest deflation. Presumably thiswas because it did not persist, and was not expected to do so—and it has to persist to
give the effect Svensson is after. Expectations of a stronger yen appear to have beenvery entrenched—after a very long period of more or less continual trend appreciation. This would not be easy to break—which only emphasizes even more the needfor the agreement of other major countries if the peg is to stand any chance of being
credible. Two other practical points in passing: the size of intervention needed may
be very large indeed by any past standard. Published data suggest that the Japanese
Ministry of Finance (MOF) has accumulated US$100 billion over the past year or sowhen the U.S. dollar-yen rate has been between ¥100 and ¥110. One can only
imagine the size of transactions that might be required to hold a higher dollar-yen
rate. Second, it is important to note that in Japan it is the MOF which owns anddeploys foreign reserves, not the central bank. So there is an issue of coordination
between policy authorities. These problems can be ignored in theoretical analysis, but
are often important in practice.
So while a small open economy can indeed generate reflation by devaluation,
Japan is not all that open, and not that small. Hence I have less confidence than00040. This is not that large a decline, of course, compared with what happened in a number of countries in the 1930s.
This helps to explain, perhaps, why the BOJ does not seem to feel that Japan is in the grip of a downward spiralof prices and output.

315

Svensson that this course of action is the “foolproof ” answer to Japan’s problems.
That is not to say that it would not help or that it should be ruled out—far from it.
But it is not foolproof.
It may be that, with Japan showing signs of recovery now, current policies will
be seen as doing the trick, so more adventurous ideas will be put back on the shelf.
I suspect, however, that should the liquidity trap intensify, we would have to lookback to domestic Japanese policies for a major part of the answer to the problems.
The problems for fiscal policy are well known. Japan has a high ratio of public debt
to GDP, and an aging population. As for “unorthodox” monetary measures, it is argued
that more open market purchases of financial assets will have little expansionary effect.
Other suggestions would be for direct purchases of other assets or, in extremis, goods
and services. The objection will be made that these would expose the central bank torisks outside its usual mandate, and/or that they really amount to fiscal policy—not
monetary policy.
Perhaps what this means is that there is a policy coordination issue. “Conventional”
monetary policy—via interest rates—has run its course, and “conventional” fiscal
policy may be hampered because of the financing constraint. But a fiscal boost
financed by monetary expansion might well provide a boost for the economy in a waythat neither policy alone could manage. At the same time, there would also be a needto ensure that once the short-term emergency is past, the unorthodox measures did not
become normal, and that perceptions of the BOJ’s independence and its commitment
to long-term price stability were not undermined. Achieving the right mix—if it isfeasible at all—would be no easy task.
In conclusion, I think Svensson’s paper makes a valuable contribution byreminding us that for an open economy, monetary policy can look to the exchange
rate as a channel of influence, so that we need not necessarily despair that policy iscompletely lacking in effect even if interest rates cannot be pushed lower. And it does
so in a rigorous model, highlighting the undoubtedly crucial role of expectations, andwith an eye to reconciling short-term and long-term needs.
But I think Svensson claims too much when he says it is foolproof, if for noother reason than that I doubt that Japan can unilaterally and sustainably devalue theyen by enough to make the difference needed, without there being agreement byother major countries. This might or might not be forthcoming, but it would be
a necessary condition for the process outlined by Svensson to work.
More generally, if two years from now we are still talking about liquidity traps,
I think the search for solutions may, while not ignoring exchange rate channels,
turn mostly back to issues of domestic policy, and to issues of policy coordinationin particular.

316 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Comment

Comment
JOB SWANKThe Netherlands Bank

Lars Svensson has written a topical and thought-provoking paper, which claims tooffer a “foolproof way of escaping from a liquidity trap.” Nevertheless, having gone
through the various equations contained in the paper, I am still left with some doubt,
which centers around the issue of whether the proposed way out of a liquidity trap
will always work, whatever the conditions or the monetary transmission mechanism
may be. I shall deliver my comment as much as possible within the context of themodel presented in the paper, which I have read with great pleasure. The analyticalframework contains sufficient realistic elements to warrant a meaningful discussion of
the matters at stake. I am not sure that the results of the model are equally valid
when monetary transmission (also) proceeds through channels other than interest
rates, as the author seems to suggest. My intuition says that the possible existence ofan independent money or credit channel requires more than what is contained in themodel, especially when interest rates have reached the zero bound (real-balance
effects, for example). In this respect, the analysis does not seem to do full justice tothe recommendations made by Allan Meltzer and others during this conference. But
this aspect is not relevant to my own remarks. Furthermore, for the sake of argument,
I shall stick with Svensson to the presumption that the Japanese economy finds itself
in a liquidity trap, indeed. In order to present my points in the perspective of themodel, I shall use some simple equations borrowed or derived from the paper.
There are essentially two channels of monetary transmission in the model: (1) thereal long-term interest rate (r Tt ) with finite maturity T, and (2) the real exchange rate(qt ). The expectations of both variables, in deviation from their constant steady-statelevels (r and q, respectively), enter into the aggregate-demand equation:eT– r) + βq (q t+1– q ) + R,
yt +1 = –βρT(rt+1e(1)

with expectations formed in period t, and with R representing all other influences.
There are two instruments: (1) the short-term interest rate (i t ), and (2) foreigncurrency interventions. With a credible exchange rate target (or target path), these
instruments are interdependent in that one of both has to adjust in order to establish
interest parity, which is imposed on the model:.

i t = i *t + ste +1 + ϕ t ,(2).

where i *t is the foreign counterpart of i t , ste +1 denotes expected nominal depreciation,and ϕ t is the foreign-currency risk premium.
The gist of the proposed recipe is twofold: (1) an announced price-level target
path, and (2) an announced target path for the nominal exchange rate. This crawling
peg leads off with a devaluation of the home currency, supported by unlimited317

foreign exchange interventions, and is maintained until the real exchange rate haschanged just enough to have brought the economy on the price-level target path.
Beyond that point, a new monetary regime, with a freely floating exchange rate, will
become operative. So, in contrast with the nominal exchange rate target, the pricelevel target is hit only after some laps of time. By then, inflation and economic
growth will have reached normal levels. That is the idea, as I understand it.
Now, combining some equations in the paper, and assuming that foreign prices
are on their steady-state level, gives for the actual real exchange rate:.

qt = π̂ – π t ,(3)which formally restates that the actual real exchange rate will depreciate as long as
actual inflation (π t ) is below the target level (π̂ ). Indeed, this is the initial phase of
the plan. But the final part is that the real exchange rate must eventually appreciate toits steady-state level. And the private sector must expect this to occur. Otherwise,
investors would massively supply rather than demand domestic currency from thevery start, and the central bank would find itself in the situation of speculative attacks
described in Chapter I of Svensson’s paper, thereby “eventually risking running out of
foreign-exchange reserves.” Can this hazard be avoided? The answer is yes, provided
that the public is convinced that the central bank will manage to eventually get
actual inflation above the target level. For this is exactly what is needed for areal appreciation to occur in the final stage of the process, on the basis of the same
equation (3). Hence, the central bank must be credible, its model must give an
accurate description of the monetary transmission process, and the public—both
inside and outside the country—must share this description. This requires, at theleast, an unprecedented degree of transparency from the central bank.
In actual practice, credibility can be earned by showing that the strategy chosen
turns out to be successful in the initial stage. This would imply that inflation andeconomic growth will pick up shortly after the plan has been implemented. Is this alikely scenario? My tentative answer is: it depends. More precisely, I suspect it
depends on the monetary transmission mechanism. Let me try to show this. From
the assumptions made by the author, it can be demonstrated that the expected rate ofchange in the real exchange rate for period t+1 is given by.

e= π̂ – π te +1.
q t+1

(4)

We may safely assume that in the initial stage of the project, expected inflation willlag behind the target rate, so that the public will expect the real exchange rate todepreciate. As a result, aggregate demand is stimulated, by virtue of equation (1). The
question is, then, what happens to the real long-term interest rate, the other channelof monetary transmission to aggregate demand. From the condition of real interest
parity (equation [15] of Svensson’s paper), we can infer.

e+ ϕ t = r *t + (π̂ – π te +1) + ϕ t ,rt = r *t + q t+1

318 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

(5)

General Discussion

which is the real-term equivalence of equation (2). In other words, if the expected
real exchange rate depreciates (that is, if qt +1 is expected to rise), the real short-term
interest rate (rt ) will be high relative to its foreign counterpart (r *t ), and this willcontinue to be the case as long as the inflation target is not hit (by virtue of equation[4]). I would conjecture that the same goes for longer-term real interest rates,
provided that the maturities of the associated bonds are sufficiently limited. For
according to the expectations hypothesisT

1 re .
r Tt = ––∑ t +τ
T τ =0(6)

In Svensson’s analysis, however, there is only one long real interest rate, with therelevant maturity (T ) being sufficiently long to ensure that this rate will fall relative
to its steady-state level.
Where does this all take us? First, the analysis by Svensson is correct in itself. So
if economic reality conforms to his model, and abstracting from foreign retaliation(see below), the proposed recipe will work, provided that the central bank is credible.
My concern is that in the initial stage of the project, real interest rates with limited
maturities will rise rather than fall, notwithstanding the fact that very long real rates(as in Svensson’s model) will fall. It follows that aggregate demand, which in actual
practice reacts to the whole spectrum of real interest rates, may be partially depressed,
at least initially, and it is not self-evident that this effect will be smaller in absolute
size than the positive effect of the expected real depreciation. As a consequence,
it is not a foregone conclusion that inflation will immediately rise. It may actuallydiminish at first, depending on the relevant impact multipliers. Whether or not
this will happen, is a matter of empirical analysis, of course, but if the answer isyes, the central bank’s credibility comes into play, which is crucial for the wholething to work.
My second concern goes beyond the model and has already been elaborated bymy colleague-commentator. A long-continued depreciation of the real exchange rate
will significantly affect the economies of Japan’s trading partners in terms of inflation,
output growth, current account, etc. This is likely to invite countermeasures by thesecountries. It is clear that this may put a spoke in the wheel, and I am curious to hear
how the proposed strategy could allow for this risk.

General Discussion
In response to the skepticism expressed by Glenn Stevens and Job Swank, Lars E. O.
Svensson reemphasized that his model was built on conventional and uncontroversial
economic relations, in order to establish a foolproof way of escaping from theliquidity trap. Exactly by how much the yen should be devalued at the initial stage
is not that important, as long as it ends up clearly below the equilibrium level.
Given the importance of restoring aggregate demand in Japan for the stable growthof the world economy, it should not be difficult for trading partners to consent to a319

devaluation of the yen. Finally, credibility in the peg of the nominal exchange rate
can be easily built, perhaps in just one week or so, given that the peg is technicallyfeasible to maintain. In light of the inertia of deflation, it should take somewhat
longer to turn deflation into inflation, perhaps a year or more.
Donald L. Kohn noted that, at least in the initial stages, this proposal would have“beggar thy neighbor” effects, and added that it might be more easily accepted today,
while it would have been impossible two years ago during the East Asian crisis.
William R. White commented on the potential for coordination among policy
makers and agreed that now would be an excellent opportunity to implement
Svensson’s proposal because aggregate demand is unsustainably high in the UnitedStates and the euro seems excessively weak relative to the yen.
Masaaki Shirakawa wondered if the proposal would not violate the IMF rules,
which preclude devaluation for the purpose of stimulating the domestic economy. He
also reflected on the experience of the Plaza Accord and the Louvre Accord toillustrate how difficult it is to maintain international policy coordination for a longtime. Vítor Gaspar urged participants to take seriously the constraint deriving fromthe perception of “competitive devaluation” as “unfair.”In reply, Charles Collyns noted that the aim of the IMF’s ban on nominal
exchange rate devaluation for competitive purposes was to prevent “beggar thy
neighbor” policies that might endanger the sound development of the world
economy. The present issue over Japan is clearly not that case. Allan H. Meltzer
pointed out that what is important is how quickly the real exchange rate of theyen, which stays above the equilibrium rate, could be adjusted without incurringcosts of deflation. He felt sympathy for Svensson’s proposal in that it should be a way
to achieve this quickly. He also thought that a devaluation of the nominal exchange
rate accompanied by this kind of adjustment does not constitute a “beggar thy
neighbor” policy.
According to Kohn, there are two important caveats with regard to the credibilityof the exchange rate peg: first, the effects of this proposal would depend upon the
inflation rate of trading partners; and second, trading partners may respond byadopting easy-money policies. It would thus not be easy to build credibility of thenominal exchange rate peg, even if Japan were theoretically able to sell unlimited
amounts of yen. Takamasa Hisada said that it would not be easy in practice to bring
the nominal exchange rate to the target rate, because a large downward nudge tothe yen would be politically difficult, while a small devaluation would only delay
adjustment processes in a country like Japan, which is not that heavily dependent
on trade: Japan is certainly not a textbook case of a “small country.” Spencer Dale
noted the problem of a central bank’s balance-sheet expansion and possible losses
due to intervention. Svensson responded that if the central bank would commit itself
to unlimited intervention, the actual amount of intervention necessary for achieving
the peg might not be that large, and the central bank’s balance sheet might not
expand greatly.
With respect to the effectiveness of the exchange rate channel, Hiroshi Fujiki
pointed out that the cooperative solution for pegging the exchange rate should beobtained in a multiple-country model in which an improvement in economic welfare

320 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

General Discussion

for the trading partner could be demonstrated. John B. Taylor agreed that simulations using a multiple-country model would be beneficial in evaluating this proposal,and said that his own calculations indicated that the elasticity of aggregate demandwith regard to the exchange rate was so small that it would be inappropriate to expect
too much from the exchange rate channel.
Georg Rich described Switzerland’s experience with a temporary nominal
exchange rate peg, noting that it is difficult to influence expectation formation unlessthe authorities commit to a permanent peg. He also urged caution that policies
aiming at expanding external demand for the recovery of the economy would haveconsiderable impact on the domestic industrial structure. Marvin Goodfriend andChristian Pfister commented that an increase in the uncertainty of inflation would
raise the risk premium, which might, through uncovered interest rate arbitrage, raise
real interest rates. Svensson, however, reemphasized that his model indicated that arise in inflation expectations would result in a decline in long-term real interest rates.
He also stressed that the proposal did not exclude other measures implemented at thesame time; in particular, some other measures should be taken for coping with thefinancial crisis.
Tiff Macklem felt that “anchored expansion” was an attractive idea that integrates
existing proposals of escaping from the liquidity trap, but doubted the robustness ofa mechanism that was too heavily dependent on the movement of expectations
regarding various variables, notably expected inflation rates. Goodfriend praised the
proposal for providing a monetary solution (in the form of nominal exchange rate
devaluation) to the monetary problem of the liquidity trap. However, he also
expressed three reservations regarding (1) the risks inherent in the manipulation of
inflation expectations, (2) the difficulty of coordination between the government
and the central bank, and (3) the difficulty of forming a public consensus on theworsening of the terms of trade produced by currency devaluation. Fujiki noted
the need to articulate in advance whether exogenous shocks would be better
adjusted through the exchange rate channel or through the price level channel.
Hisada questioned whether price level targeting would be able to deal with supplyside shocks such as the productivity gains achieved by advances in informationand communication technologies.
Kazuo Ueda commented that Svensson was mistaken if he interpreted the BOJ’smonetary policy stance as an unwillingness to implement policies the effects of which
are uncertain. He added that any policy will have costs and benefits depending upon
economic conditions at the time of its implementation, and it is necessary to choose
the most appropriate one among the policy options available under the constraints,
as pointed out by Goodfriend earlier. He concluded by stressing that the BOJ
maintained the zero interest rate policy in light of all the costs involved.

321322 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001