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How to escape a liquidity trap with interest rate rules

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Abstract
I study how central banks should communicate monetary policy in liquidity trap scenarios in which the zero lower bound on nominal interest rates is binding. Using a standard New Keynesian model, I argue that the key to anchoring expectations and preventing self-fulfilling deflationary spirals is to promise to keep nominal interest rates pegged at zero for a length of time that depends on the state of the economy. I derive necessary and sufficient conditions for this type of state-contingent forward guidance to implement the welfare-maximizing equilibrium as a globally determinate (that is, unique) equilibrium. Even though the zero lower bound prevents the Taylor principle from holding, determinacy can be obtained if the central bank sufficiently extends the duration of the zero interest rate peg in response to deflationary or contractionary changes in expectations or outcomes. Fiscal policy is passive, so it plays no role for determinacy. The interest rate rules I consider are easy to communicate, require little institutional change, and do not entail any unnecessary social welfare losses.

Suggested Citation

  • Fernando M. Duarte, 2016. "How to escape a liquidity trap with interest rate rules," Staff Reports 776, Federal Reserve Bank of New York.
    • Handle: RePEc:fip:fednsr:776
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    References listed on IDEAS

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    Cited by:

    1. Tobias Adrian & Fernando M. Duarte, 2016. "Financial vulnerability and monetary policy," Staff Reports 804, Federal Reserve Bank of New York.
    2. Fernando M. Duarte & Benjamin K. Johannsen & Leonardo Melosi & Taisuke Nakata, 2020. "Strengthening the FOMC’s Framework in View of the Effective Lower Bound and Some Considerations Related to Time-Inconsistent Strategies," Finance and Economics Discussion Series 2020-067, Board of Governors of the Federal Reserve System (U.S.).
    3. Gerke, Rafael & Hauzenberger, Klemens, 2017. "The Fisher paradox: A primer," Discussion Papers 20/2017, Deutsche Bundesbank.
    4. Robert Amano & Thomas J. Carter & Rhys R. Mendes, 2016. "Comparing Forward Guidance and Neo-Fisherianism as Strategies for Escaping Liquidity Traps," Staff Analytical Notes 16-16, Bank of Canada.

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    More about this item

    Keywords

    zero lower bound (ZLB); liquidity traps; New Keynesian model; indeterminacy; monetary policy; Taylor rule; Taylor principle; interest rate rules; forward guidance;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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