Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others

TLDR

Existing proposals to escape a liquidity trap and deflation, including the Foolproof Way, are evaluated against an optimal strategy, with currency depreciation serving as a key indicator of expectations for a higher future price level. The optimal escape strategy requires (1) a central‑bank commitment to a higher future price level, (2) a concrete action that signals this commitment and stimulates expectations and economic activity, and (3) a clear exit plan for returning to normal. The Foolproof Way, using intentional depreciation and a crawling peg, can trigger the optimal strategy and is expected to work effectively for Japan, the euro area, and the United States if they enter a liquidity trap.

Abstract

Existing proposals to escape from a liquidity trap and deflation, including my “Foolproof Way,” are discussed in the light of the optimal way to escape. The optimal way involves three elements: (1) an explicit central-bank commitment to a higher future price level; (2) a concrete action that demonstrates the central bank's commitment, induces expectations of a higher future price level and jump-starts the economy; and (3) an exit strategy that specifies when and how to get back to normal. A currency depreciation is a direct consequence of expectations of a higher future price level and hence an excellent indicator of those expectations. Furthermore, an intentional currency depreciation and a crawling peg, as in the Foolproof Way, can implement the optimal way and, in particular, induce the desired expectations of a higher future price level. I conclude that the Foolproof Way is likely to work well for Japan, which is in a liquidity trap now, as well as for the euro area and the United States, in case either would fall into a liquidity trap in the future.