Friday, 20 September 2013

Currency depreciation

The liquidity trap hypothesis implies that countries are unable to devalue their currencies in the forex markets. There are several ways of answering this. A liquidity trap implies the central bank cannot inflate, but currency devaluation tends to raise the price level.

We have been taught that “liquidity traps” are all about the zero lower bound on nominal interest rates, but on closer inspection it is actually another zero bound that is crucial, the zero lower bound on eligible assets not purchased by the central bank.

Keynesian objections are:

1. The central bank can only legally buy certain assets.
2. The central bank may be fearful of having a large balance sheet.

Those objections then become the real reason for monetary policy ineffectiveness, not the zero bound.

In order to peg the exchange rate at a lower level they would have to sell so much domestic currency that their balance sheet would swell to unacceptable levels.

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