Essays on monetary policy, disinflation and deflation (Japan)

This dissertation analyses U.S. monetary policy over 1979--2004; how monetary policy can help avoid the liquidity trap; and how economies can escape from the liquidity trap. Chapter 2 proposes a method of estimating the Taylor rule that allows the implicit inflation target and natural rate of interest to vary. I apply this method to U.S. monetary policy over 1979--2004. Stability tests indicate significant variation in the target and the estimated path of the target is corroborated by historical evidence. Chapter 3 investigates how monetary policy can avoid the liquidity trap by studying the experience of Japan. First, I analyze how the Bank of Japan set interest rates over the 1990s as the economy entered a deflationary slump. I find that the Bank's implicit inflation target declined to about 1% in the 1990s from about 2.5% in the 1980s. However, the policy rule respects the Taylor principle and does not depart from what was perceived as best practice. It thus seems that the problem arose because of adverse shocks and not because of an extraordinary monetary policy mistake. Next, I investigate whether an alternative policy rule could have avoided the liquidity trap despite these shocks. Using counter-factual simulations, I find that a rule that combined both (i) a higher inflation target of about 3%, and (ii) a more aggressive response to the inflation gap would have avoided the zero bound. Chapter 4 examines the optimal choice of a monetary policy rule for a small open economy in a liquidity trap. For a closed economy in a liquidity trap, the optimal policy is a consumer price index (CPI) targeting rule. However, in an open economy, instead of targeting the CPI level, the optimal policy involves targeting the domestic price level. CPI targeting is suboptimal in an open economy because it amplifies inflation fluctuations. The behaviour of the economy under the optimal price targeting rule and under domestic inflation targeting is identical when the interest rate is above zero. However, when the economy is in the liquidity trap, targeting domestic inflation exacerbates the consequences of the zero bound.