Conservatism and Liquidity Traps
In an economy with an occasionally binding zero lower bound (ZLB) constraint, the anticipation of future ZLB episodes creates a trade-off for discretionary central banks between inflation and output stabilization. As a consequence, inflation systematically falls below target even when the policy rate is above zero. Appointing Rogoff’s (1985) conservative central banker mitigates this deflationary bias away from the ZLB and enhances welfare by improving allocations both at and away from the ZLB.
Over the past few decades, a growing number of central banks around the world have adopted inflation targeting as a policy framework. The performance of inflation targeting in practice has been widely considered a success. However, some economists and policymakers have voiced the need to re-examine central banks’ monetary policy frameworks in light of the liquidity trap conditions currently prevailing in many advanced economies. As shown in Eggertsson and Woodford (2003) among others, the zero lower bound (ZLB) on nominal interest rates severely limits the ability of inflation-targeting central banks to stabilize the economy absent an explicit commitment technology. Some argue that the ZLB is likely to bind more frequently and that liquidity trap episodes might hit the economy more severely in the future than they have in the past. Understanding the implications of the ZLB for the conduct of monetary policy is therefore of the utmost importance for economists and policymakers alike.