Sunday, March 1, 2009

How to get out of a liquidity trap?

Given the high probability that the Bank of Canada will inch ever closer to the zero bound when it cuts its overnight rate Tuesday, it may be a good time to ask – just how the hell do we get out of this? Here is an non-exhaustive list of ideas:

  • Credible adherence to an inflation or price level target – if credible, an inflation target anchors expectations so that a bad equilibrium of unacceptably low inflation or deflation is less likely (this deserves a post of its own, but not right now).
  • Assuming fiscal policy is non-Ricardian, the Government could promise to run huge fiscal deficits if inflation falls below a certain threshold.

  • Central Bank open market operations in the market for long-term bonds – Goodfriend (2000) argues that such purchases could substantially increase monetary liquidity and therefore inflation expectations.

Given the above list, it would seem that Canada is well placed to get itself out of the liquidity trap. The Bank of Canada has a credible inflation target and therefore much of the work in anchoring inflation expectations has already been done. Moreover, the government has committed itself to running deficits for at least two years, and the Bank has recently announced that it will begin accepting corporate bonds as collateral in its repo arrangements, although this program is largely targeted at reducing spreads rather than altering expectations. All in all, I think this should provide Canadians with some optimism about digging ourselves out of this situation.

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