How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible

IMF Working Papers, March 1, 2003

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How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible

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Bibliographic details

• Authors: Gauti B. Eggertsson
• Published: March 1, 2003
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781451848588.001

Model and central diagnosis

• Framework: microfounded general equilibrium model with zero nominal interest rate.
• Key diagnosis: deflation can be analyzed as a credibility problem when:
  • the government has only one policy instrument: money supply via open market operations in short-term bonds, and
  • the government cannot commit to future policies.
• Mechanism: lack of credible commitment to future higher money supply leads the private sector to expect deflation, sustaining a liquidity trap.

Main findings

• Credibility failure is central to persistent deflation at the zero lower bound.
• Credible commitment to higher future money supply induces private agents to expect inflation instead of deflation.
• Expected inflation lowers the real rate of return and thereby increases output.
• Such a commitment is characterized in the paper as the government credibly "commits to being irresponsible."

Policy proposals (to solve the credibility problem)

• Use monetary expansion (printing money or nominal debt) combined with one of:
  • cutting taxes,
  • buying real assets such as stocks,
  • purchasing foreign exchange.
• These policies allow the government to credibly commit to higher future money supply so that inflation expectations rise.

Rationale and optimality

• Committing to higher future money supply is optimal in this setting because:
  • it curbs deflation,
  • it increases output by lowering the real rate of return.

Subject areas and keywords

• Subject: Banking, Central banks, Deflation, Inflation, Inflation targeting, Monetary base, Monetary policy, Money, Open market operations, Prices
• Keywords: deficit spending, Deflation, deflation bias, Inflation, inflation bias, inflation expectation, Inflation targeting, liquidity traps, Monetary base, monetary policy, money supply, nominal interest rate, Open market operations, price level, WP, zero bound on nominal interest rates

Content in this bundle

• How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible - WP/03/64, Corrected
  • How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible - WP/03/64, Corrected (Markdown version)
  • How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible - WP/03/64, Corrected (PDF)