A liquidity trap and deflationary spiral in a model for pursuing an inflation target – the role of credibility
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Reaching the lower limit of the nominal interest rate may have grave effects on the equilibrium and stability of the macro economy. Then the negative shock effects that threaten recession and too low a level of inflation cannot be absorbed by traditional measures of interest policy, and the economy, in the absence of other types of demand-stimulating measures, may easily slip into a state where the interest level stabilizes at a minimum value, and a spiral of decreasing output and price level results. This theoretical study uses a simple, stylized macroeconomic model to examine the possibility of such situations occurring. The formally deduced conditions for a liquidity trap and deflationary spiral to ensue show how the limits on the scope of interest policy are affected by the setting of the inflation target, the equilibrium level of real interest rate characteristic of the economy, the character and strength of the shock effects, the extent of the central bank's interest-rate reactions to these, and the credibility of the inflation target. The conclusions can be seen in parallel with the results of model calculations on the likelihood of the liquidity trap, and generally accepted recommendations for avoiding or remedying this. The model shows that the likelihood of reaching a zero interest rate can never in theory fall to zero, but entry into the deflationary spiral of a liquidity trap can be excluded in principle if attainment of the inflation target has a high degree of credibility.
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