Optimal Monetary Policy in a Liquidity Trap

We consider the consequences for monetary policy of the zero floor for nominal interest rates.The zero bound can be a significant constraint on the ability of a central bank to combat deflation.We show, in the context of an intertemporal equilibrium model, that open-market operations, even of "unconventional" types, are ineffective if they do not change expectations about the future conduct of policy; in this sense, a "liquidity trap" is possible.Nonetheless, a credible commitment to the right sort of history-dependent policy can largely mitigate the distortions created by the zero bound.In our model, optimal policy involves a commitment to adjust interest rates so as to achieve a timevarying price-level target, when this is consistent with the zero bound.We also discuss ways in which other central-bank actions, while irrelevant apart from their effects on expectations, may help to make credible a central bank's commitment to its target, and consider implications for the policy options currently available for overcoming deflation in Japan.