Comparing forward guidance and neo-Fisherianism as strategies for escaping liquidity traps / by Robert Amano, Thomas Carter and Rhys Mendes. : FB3-7/2016-16E-PDF

What path should policy-makers select for the nominal rate when faced with a liquidity trap during which the effective lower bound binds? Conventional wisdom has generally favoured a commitment to keep rates low for long, namely under the guise of forward guidance policies, while Cochrane (2016) and others have recently made the case for neo-Fisherian policies that involve pegging rates at a high level in the hopes that the Fisher effect might deliver higher inflation over time. We compare these two options as strategies for escaping liquidity traps and argue that their relative merits likely depend on the mechanism that initially gave rise to the particular trap in question. More specifically, we argue that policy-makers should distinguish between “shock-based” traps that arise following large, negative demand shocks (Eggertsson and Woodford 2003) and “expectation-based” traps that arise from self-fulfilling shifts in private sector expectations (Benhabib, Schmitt-Grohe and Uribe 2001). This is because forward guidance likely dominates in the former case, while the latter may favour neo-Fisherianism to the extent that keeping rates low for long might reinforce the pessimistic beliefs underlying expectation-based traps. Although empirical strategies for distinguishing between these two mechanisms would be a promising topic for future research, we conclude by arguing that the shock-based mechanism likely provides a more plausible explanation for the low inflation witnessed in many developed countries during and after the Great Recession.

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