Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others

Lars E.O. Svensson

NBER Working Paper No. 10195
Issued in December 2003
NBER Program(s):   IFM   ME

Existing proposals to escape from a liquidity trap and deflation, including my Foolproof Way,' are discussed in the light of the optimal way to escape. The optimal way involves three elements: (1) an explicit central-bank commitment to a higher future price level; (2) a concrete action that demonstrates the central bank's commitment, induces expectations of a higher future price level and jump-starts the economy; and (3) an exit strategy that specifies when and how to get back to normal. A currency depreciation is a direct consequence of expectations of a higher future price level and hence an excellent indicator of those expectations. Furthermore, an intentional currency depreciation and a crawling peg, as in the Foolproof Way, can implement the optimal way and, in particular, induce the desired expectations of a higher future price level. I conclude that the Foolproof Way is likely to work well for Japan, which is in a liquidity trap now, as well as for the euro area and the United States, in case either would fall into a liquidity trap in the future.

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Document Object Identifier (DOI): 10.3386/w10195

Published: Svensson, Lars O. "Escaping From A Liquidity Trap And Deflation: The Foolproof Way And Others," Journal of Economic Perspectives, 2003, v17(4,fall), 145-166. citation courtesy of

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