Price Level Dynamics in a Liquidity Trap

Author Name WATANABE Tsutomu  (Faculty Fellow) /IWAMURA Mitsuru
Creation Date/NO. January 2003 03-E-002
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This paper studies the dynamic behavior of the general price level when the natural rate of interest declines substantially. Particular attention is paid to two constraints: the non-negativity constraint of nominal interest rates, and the government's intertemporal budget constraint. In a normal situation, nominal bond prices rise in response to the shock, which restores equilibrium. However, if the non-negativity constraint is binding, nominal bond prices cannot rise sufficiently. Equilibrium can then be restored only by a sufficient fall in the current price level. The required fall is greater when the maturity of government debt is shorter. To avoid deflation, the government must coordinate with the central bank by committing itself to reducing the current and future primary surplus.