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

I n the last decade or two, central banks all over the world have been quite successful in achieving low and stable in ation. Average annual in ation in the industrialized countries has fallen below 2 percent. Average in ation has not been so low since the 1950s, as shown in Table 1. In emerging countries, in ation is now the lowest since the 1960s (International Monetary Fund, 2003b). These gains against in ation are good news. They have brought substantial beneŽ ts in terms of reduced distortions, less uncertainty and improved resource allocation. But they also raise new risks. Unanticipated negative shocks to demand or supply can cause recessions and lower in ation—and, starting from a low in ation level, even de ation. In such a situation, the appropriate response by central banks is to lower interest rates and, in this way, stimulate the economy out of recession and too low in ation. But with low in ation or even de ation, a negative interest rate may be required to provide sufŽ cient stimulus to the economy, whereas nominal interest rates cannot fall below zero. The economy might then become caught in a liquidity trap and a prolonged recession and de ation. This paper begins with a discussion of the causes and consequences of a liquidity trap and de ation, with some emphasis on Japan’s experience since the 1990s. It then discusses policy options for preventing a liquidity trap and de ation from occurring and for escaping from a liquidity trap and de ation if they have already occurred. Whereas policy for avoiding a liquidity trap and de ation is less controversial, there is a fair amount of controversy about the range of policies to escape from a liquidity trap and de ation, including my own proposal, the “Foolproof Way” (Svensson, 2001, 2002).