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Journal of Economic Perspectives: Vol. 17 No. 4 (Fall 2003)

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

Article Citation

Svensson, Lars E. 2003. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others." Journal of Economic Perspectives, 17(4): 145-166.

DOI: 10.1257/089533003772034934

Abstract

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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Authors

Svensson, Lars E.O.

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