Business Intelligence

Liquidity Traps: An Interest-Rate-Based Exit Strategy

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Executive Summary

This paper analyzes a potential strategy for escaping liquidity traps. The strategy is based on an augmented Taylor-type interest-rate feedback rule and differs from usual specifications in that when inflation falls below a threshold, the central bank temporarily deviates from the traditional Taylor rule by following a deterministic path for the nominal interest rate. This path reaches the intended target for this policy instrument in finite time. The policy the authors study is designed to raise inflationary expectations over time while at the same time maintaining all of the desirable local properties of the Taylor principle in a neighborhood of the intended inflation target.

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