A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap

Bennett T. McCallum

NBER Working Paper No. 11056
Issued in January 2005
NBER Program(s):   EFG   ME

In analyses of "liquidity trap" problems associated with the zero lower bound (ZLB) on nominal interest rates, it is important to emphasize the difference between policy rule changes, intended to help escape an existing ZLB situation, and maintained policy rules designed so as to avoid ZLB situations. Analysis assuming that rule changes would lead to a new RE equilibrium immediately seems implausible. Accordingly, the paper focuses on the design of a rule that should retain stabilization effectiveness even if the economy is temporarily shocked into a ZLB situation.

The rule considered is one that uses as its instrument variable a weighted average of an interest rate and the rate of depreciation of the nominal exchange rate. With a small weight attached to the depreciation term, it will be nearly irrelevant in normal situations but call for strong adjustments when the ZLB condition prevails. Stabilizing properties of this "MC" rule are studied within a small open economy model developed by McCallum and Nelson. Results indicate that under ZLB conditions the MC rule will provide strong stabilizing policy actions yet, under conditions such that the ZLB constraint is not relevant, the MC rule need not hinder monetary policy.

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Document Object Identifier (DOI): 10.3386/w11056

Published: A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap, Bennett T. McCallum . in Monetary Policy with Very Low Inflation in the Pacific Rim, NBER-EASE, Volume 15, Ito and Rose. 2006

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