Following the introduction of inflation targeting and related monetary strategies, target inflation seems to have fallen to relatively low rates, about 2 to 3 per cent in many countries. This implies that large adverse shocks might push the economy into periods of deflation. This was clearly a major concern in the United States during the 2001 recession. The experiences of 2008 and 2009, as well as the earlier experience of Japan since the 1990s, have underlined these concerns and created a situation in which the monetary policy response is constrained by the zero lower bound on nominal interest rates – a phenomenon sometimes called a ‘liquidity trap’. Furthermore, in a liquidity trap there is the potential for the economy to get stuck in a deflationary situation with declining or persistently low levels of output.
The theoretical plausibility of the economy becoming trapped in a deflationary state, and the macroeconomic policies that might be able to avoid or extricate the economy from a liquidity trap, have been examined predominantly from the rational expectations (RE) perspective. One central feature of this literature emphasises the role of commitment. For example, Krugman (1998) and Eggertsson and Woodford (2003) argue that, if the economy encounters a liquidity trap, monetary policy should be committed to being expansionary for a considerable period of time, by keeping interest rates near zero even after the economy has emerged from deflation. Another issue concerns the possibility of permanent deflation.
Email your librarian or administrator to recommend adding this to your organisation's collection.