
Liquidity Trap and Optimal Monetary Policy: Evaluations for U.S. Monetary Policy
Abstract
This paper shows that the Fed’s exit strategy works as optimal monetary policy in a liquidity trap. We use the conventional new Keynesian model including a recent inflation persistence and confirm several similarities between optimal monetary policy and the Fed’s monetary policy. The zero interest rate policy continues even after inflation rates are sufficiently accelerated over the 2 percent target and hit a peak. Under optimal monetary policy, the zero interest rate policy continues until the second quarter of 2022 and the Fed terminates it one quarter earlier. Eventually, inflation rates exceed the target rate for over three years until the latest quarter. The policy rates continue to overshoot the longrun level to suppress high inflation rates. Furthermore, high inflation rates under optimal monetary policy can explain about 70 percent of the inflation data for 2021 and 2022 years. However, these are still lower than the inflation data. This is because optimal monetary policy raises the policy rates faster than the Fed does. The remaining 30 percent of inflation rates can be constrained by the Fed’s more aggressive monetary policy tightening after the zero interest rate policy.
Introduction
The theory of monetary policy has been developed since the 1990s based on a new Keynesian model as represented by Clarida et al. (1999) and Woodford (2003). Woodford (2003) finds history dependence as a general property of optimal monetary policy with commitment in a purely forwardlooking new Keynesian model. He shows that the forwardlooking economy and history dependence are two sides of a coin in optimal monetary policy. Eggertsson and Woodford (2003b,a), Jung et al. (2001, 2005), and Adam and Billi (2006) extend optimal monetary policy analysis with commitment to an economy in a liquidity trap and show that a robust conclusion about a feature of optimal monetary policy is history dependence. The consequence of optimal monetary policy under commitment in a liquidity trap is predicted by these papers. However, such predictions have not been evaluated in the past two decades. Now, we show the answer.WP051