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

Must-Read: Lars E.O. Svennson (2003): Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others: "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.

http://www.nber.org/papers/w10195

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