Liquidity Trap and Optimal Monetary Policy Revisited
This paper investigates history dependent easing known as a conventional wisdom of optimal monetary policy in a liquidity trap. We show that, in an economy where the rate of inflation exhibits intrinsic persistence, monetary tightening is earlier as inflation becomes more persistent. This property is referred as early tightening and in the case of a higher degree of inflation persistence, a central bank implements front-loaded tightening so that it terminates the zero interest rate policy even before the natural rate of interest turns positive. As a prominent feature in a liquidity trap, a forward guidance of smoothing the change in inflation rates contributes to an early termination of the zero interest rate policy.
The theory of monetary policy has been developed since 1990s based on a new Keynesian model as represented by Clarida et al. (1999) and Woodford (2003). In particular, Woodford (2003) finds history dependence as a general property of optimal monetary policy. The optimal monetary policy rule explicitly includes lagged endogenous variables and the current monetary policy reflects the past economic environment.