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

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 inflat...

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Bibliographic Details
Published in:The American economic review 2007-03, Vol.97 (1), p.474-490
Main Authors: Jeanne, Olivier, Svensson, Lars E. O
Format: Article
Language:English
Subjects:
Balance sheets
Capital losses
Central banks
Consumer Price Index
Credibility
Deficit financing
Foreign exchange rates
Inflation
Interest rates
Liquidity
Monetary policy
Price levels
Reserve assets
Studies
Taxation
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Summary: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)
ISSN:0002-8282
1944-7981
DOI:10.1257/aer.97.1.474