Question

LIQUIDITY TRAP

Some economists advocate for fixing the exchange rate for economies in a liquidity trap. Specifically, they recommend pegging the exchange rate at a depreciated level (higher than the upper bound S^MAX). Using the DD-AA model, show how to escape from a liquidity trap using a fixed exchange rate.

Answer 1

➜ Liquidity trap occurs if a) banks are willing to hold virtually unlimited excess reserves rather than expand their balance sheets by taking deposits and making loans and/or b) demand for money balances by households and companies is insensitive to the level of income. In a liquidity trap, monetary policy will be ineffective and the AD curve will not shift despite the central bank's efforts. Some have argued that this was a reasonable description of the US situation in 2010.

➜ In the conventional fixed-rate system, the exchange rate may be pegged to a single currency-for example, the US dollar-or to a basket index of the currencies of major trading partners.

➜ There is a band of up to ±1 percent around the parity level within which private flows are allow to determine the exchange rate .

➜ The monetary authority stands ready to spend its foreign currency reserves, or buy foreign currency. In order to maintain the e within these bands.

➜ The credibility of the fixed parity depends on the country's willingness and ability to offset imbalances in private sector demand for its currency

➜ Both excess and deficient private demand for the currency can exert pressure to adjust or abandon the parity. Excess private demand for the domestic currency Implies a rapidly growing stock of foreign exchange reserves, expansion of the domestic money supply, and potentially accelerating inflation

➜ Deficient demand for the currency depletes foreign exchange reserves and exerts deflationary pressure on the economy.

➜ If market participants believe the foreign exchange reserves are insufficient to sustain the parity, then that belief may be self-fulfilling because the resulting speculative attack will drain reserves and may force an immediate devaluation.

➜ Thus, the level of reserves required to maintain credibility is a key issue for a simple fixed exchange rate regime.