Working Paper

Reputation and Liquidity Traps

Abstract: Can the central bank credibly commit to keeping the nominal interest rate low for an extended period of time in the aftermath of a deep recession? By analyzing credible plans in a sticky-price economy with occasionally binding zero lower bound constraints, I find that the answer is yes if contractionary shocks hit the economy with sufficient frequency. In the best credible plan, if the central bank reneges on the promise of low policy rates, it will lose reputation and the private sector will not believe such promises in future recessions. When the shock hits the economy sufficiently frequently, the incentive to maintain reputation outweighs the short-run incentive to close consumption and inflation gaps, keeping the central bank on the originally announced path of low nominal interest rates.

Keywords: Credible policy; forward guidance; reputation; sustainable plan; time consistency; trigger strategy; zero lower bound;

JEL Classification: E32; E52; E61; E62; E63;

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2014-06-17

Number: 2014-50

Pages: 63 pages