The Liquidity Trap: Limits for Monetary Policy at the Effective Lower Bound

Jin Cao () and Gerhard Illing
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Gerhard Illing: LMU Munich

Chapter 7 in Money: Theory and Practice, 2019, pp 221-249 from Springer

Abstract: Abstract In this chapter, we explicitly take into account the constraint imposed by the effective lower bound. We show that under this constraint the central bank should aim to keep interest rates low for a long period, in order to stimulate current demand by committing to low long-term rates. We illustrate this feature in a highly stylized three-period framework, characterizing explicitly the optimality conditions involved, and show that there is a problem of dynamic inconsistency, creating a deflation bias. This lesson had a strong impact on actual policy design. The notion of forward guidance, which plays a key role in unconventional policies, follows naturally from commitment to optimal interest rate policy at the zero lower bound. The attempt to communicate and commit in a transparent way to keep the path of short-term interest rates low for an extended period far into the future is a key element of optimal policy.

Date: 2019
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DOI: 10.1007/978-3-030-19697-4_7

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