During the long economic slump in Japan, monetary policy in Japan has essentially consisted of a very low interest rate (since 1995), a zero interest rate (since 1999), and quantitative easing (since 2001). The intention seems to have been to lower expectations of future interest rates. But the problem in a liquidity trap (when the zero lower bound on the central bank’s instrument rate is strictly binding) is rather to raise private-sector expectations of the future price level. Increased expectations of a higher future price level are likely to be much more effective in reducing the real interest rate and stimulating the economy out of a liquidity trap than a further reduction of already very low expectations of future interest rates. Therefore, monetarypolicy alternatives in a liquidity trap should be assessed according to how effective they are likely to be in affecting private-sector expectations of the future price level. Expectations of a higher future price level would lead to current depreciation of the currency. Quantitative easing would induce expectations of a higher price level if it were expected to be permanent. The absence of a depreciation of the yen and other evidence indicates that the quantitative easing is not expected to be permanent. In an open economy, the Foolproof Way (consisting of a price-level target path, currency depreciation and commitment to a currency peg and a zero interest rate until the price-level target path has been reached) is likely to be the most effective policy to raise expectations of the future price level, stimulate the economy, and escape from a liquidity trap. It is the first-best policy to end stagnation and deflation in Japan. The Foolproof Way without the explicit exchange-rate policy, namely a price-level target path and a commitment to a zero interest rate until the price-level target path has been reached, would be a second-best policy. The current policy, a commitment to a zero interest rate until inflation has become nonnegative is at best a third-best policy, since it accommodates all deflation that has occurred before inflation turns nonnegative and therefore is not effective in inducing inflation expectations.
