Monetary and Fiscal Policy to Escape from a Deflationary Trap

Download or read book Monetary and Fiscal Policy to Escape from a Deflationary Trap written by Yasushi Iwamoto and published by . This book was released on 2004 with total page 72 pages. Available in PDF, EPUB and Kindle. Book excerpt: This paper provides a theoretical overview of monetary and fiscal policy with the potential to engineer an exit from a deflationary trap, defined here as sustained deflation in the presence of zero interest rates. It is found that the required policy steps are an interest rate hike, a commitment to future currency growth, and a money-financed tax cut. The amount of tax cut required is equal to the increase in the central bank's payments to the treasury resulting from the higher inflation rate (nominal interest rate), while fiscal policymakers must maintain fiscal discipline by stabilizing government debt and the primary balance. There will be a temporary fall in output when prices are sticky, but this is the price that must be paid to conquer deflation. The current commitment to quantitative easing is based on the assumption that the natural interest rate has temporarily declined. If the economy is in a deflationary trap, however, the continuation of zero interest rates reinforces deflationary expectations and may make it perpetually impossible to eliminate deflation. Even under conditions in which the natural rate of interest looks to be positive, if deflation persists, it is probably wise to consider a policy approach that assumes deflationary trap conditions. With this in mind, the conditions required for abandoning the current policy regime should include, in addition to consistently positive growth in the CPI, a consideration of the trend in real GDP.