Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank

American Economic Review · 2007 · Volume 97 · Issue 1

Abstract

Central banks target CPI inflation; independent central banks are concerned about their balance sheet and the level of their capital. The first fact makes it difficult for a central bank to implement the optimal escape from a liquidity trap, because it undermines a commitment to overshoot the inflation target. We show that the second fact provides a solution. Capital concerns provide a mechanism for an independent central bank to commit to inflate ex post. The optimal policy can take the form of a currency depreciation combined with a crawling peg, a policy advocated by Svensson as the "Foolproof Way" to escape from a liquidity trap. (JEL E31, E52, E58, E62)

Keywords

Monetary Policy, Central Banks and Their Policies

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