Liquidity Trap in an Inflation-Targeting Framework: A Graphical Analysis

Abstract

This paper presents a simple inflation-targeting model with alternative assumptions regarding the conduct of monetary policy. The central bank is assumed to either follow a Taylor rule or minimize a social welfare loss function. The model can be tractably described by means of a straightforward graphical apparatus, which, so far, has not been extended to include the treatment of the liquidity trap. The paper presents an analysis of the zero nominal interest rate bound using this apparatus and discusses the implications of preemptive monetary easing when the macroeconomic conditions suggest that the bound may restrict future monetary policy effectiveness.

Keywords: Inflation Targeting, Liquidity Trap, Zero Interest Rate Bound, Preemptive Monetary Policy

JEL Classification: A22, E52, E58