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The Power of Unconventional Monetary Policy in a Liquidity Trap

Masayuki Inui and Sohei Kaihatsu
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Masayuki Inui: Bank of Japan

No 16-E-16, Bank of Japan Working Paper Series from Bank of Japan

Abstract: In this study, we examine what unconventional monetary policy measures are effective in escaping from a liquidity trap. We develop a heterogeneous agent New Keynesian model with uninsurable income uncertainty and a borrowing constraint. We show that adverse effects of income uncertainty deteriorate in the liquidity trap, which crucially undermines the transmission mechanism of unconventional monetary policy through an increase in precautionary savings. We then draw the following implications: (1) decreasing risk premiums by quantitative easing (QE) is more effective than forward guidance (FG) in the liquidity trap; (2) when the liquidity trap becomes deeper, central banks should conduct QE with sufficiently rapid pace of asset purchases; and (3) the combination of QE and FG yields synergy effects that strengthen the power to escape from the liquidity trap through mitigating precautionary saving motives.

Keywords: unconventional monetary policy; liquidity trap; uninsurable income uncertainty; incomplete market; quantitative easing; forward guidance (search for similar items in EconPapers)
JEL-codes: E21 E31 E52 E58 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
Date: 2016-11-11
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