
Role of Expectation in a Liquidity Trap
Abstract
This paper investigates how expectation formation affects monetary policy effectiveness in a liquidity trap. We examine two expectation formations: (i) different degrees in anchoring expectation and (ii) different degrees in forwardlookingness to form expectation. We reveal several points as follows. First, under optimal commitment policy, expectation formation for an inflation rate does not markedly change the effects of monetary policy. Second, contrary to optimal commitment policy, the effects of monetary policy significantly change according to different inflation expectation formations under the Taylor rule. The reductions to an inflation rate and the output gap are mitigated if the expectation is well anchored. This rule, however, can not avoid large drops when the degree of forwardlookingness to form expectation decreases. Third, a simple rule with pricelevel targeting shows some similar outcomes according to different expectation formations as the Taylor rule does. However, in a simple rule with pricelevel targeting, an inflation rate and the output gap drop less severe due to a history dependent easing and are less sensitive to expectation formations than in the Taylor rule. Even for the Japanese economy, the effects of monetary policy on economic dynamics significantly change according to expectation formations for rules except optimal commitment policy. Furthermore, when the same expectation formations for the output gap are assumed, we observe similar outcomes.
Introduction
Expectation is one of the most important factors in the conduct of monetary policy. In particular, managing expectation of an agent is a nontrivial tool in a liquidity trap since the central bank faces limitation in reducing the policy interest rate. A lot of papers, such as Eggertsson and Woodford (2003b), Jung, Teranishi, and Watanabe (2005), Adam and Billi (2006, 2007), and Nakov (2008), analyze optimal monetary policy in a liquidity trap and conclude that optimal commitment policy is very effective. The commitment policy can reduce the real interest rate and stimulate the economy by controlling the inflation expectation. Their conclusions, however, are solely dependent on two important assumptions, i.e., rational expectation and optimal commitment monetary policy.