The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap

The paper examines the transmission mechanism of monetary policy in an open economy with and without a binding zero bound on nominal interest rates. In particular, a foolproof way of escaping from a liquidity trap is suggested, consisting of a price-level target path, a devaluation of the currency and an exchange-rate peg, which is later abandoned in favor of price-level or inflation targeting when the price-level target is reached. This will jump-start the economy by a real depreciation of the domestic currency, a lower long real interest rate, and increased inflation expectations. The abandonment of the exchange-rate peg and shift to price-level or inflation targeting will avoid the risk of overheating. Some conclusions for Japan are also included.