Optimal Monetary Policy in a Liquidity Trap

Gauti B. Eggertsson, Michael Woodford

NBER Working Paper No. 9968
Issued in September 2003
NBER Program(s):Economic Fluctuations and Growth, Monetary Economics

We consider the consequences for monetary policy of the zero floor for nominal interest rates. The zero bound can be a significant constraint on the ability of a central bank to combat deflation. We show, in the context of an intertemporal equilibrium model, that open-market operations, even of unconventional' types, are ineffective if they do not change expectations about the future conduct of policy; in this sense, a liquidity trap' is possible. Nonetheless, a credible commitment to the right sort of history-dependent policy can largely mitigate the distortions created by the zero bound. In our model, optimal policy involves a commitment to adjust interest rates so as to achieve a time-varying price-level target, when this is consistent with the zero bound. We also discuss ways in which other central-bank actions, while irrelevant apart from their effects on expectations, may help to make credible a central bank's commitment to its target, and consider implications for the policy options currently available for overcoming deflation in Japan.

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Document Object Identifier (DOI): 10.3386/w9968

Published: Eggertsson, Gauti B. and Michael Woodford. "The Zero Bound On Interest Rates And Optimal Monetary Policy," Brookings Papers on Economic Activity 34, 2003-1 (2003): 139-235.