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The Power of Unconventional Monetary Policy in a Liquidity Trap

November 11, 2016
Masayuki Inui*1
Sohei Kaihatsu*2


In this study, we examine what unconventional monetary policy measures are effective in escaping from a liquidity trap. We develop a heterogeneous agent New Keynesian model with uninsurable income uncertainty and a borrowing constraint. We show that adverse effects of income uncertainty deteriorate in the liquidity trap, which crucially undermines the transmission mechanism of unconventional monetary policy through an increase in precautionary savings. We then draw the following implications: (1) decreasing risk premiums by quantitative easing (QE) is more effective than forward guidance (FG) in the liquidity trap; (2) when the liquidity trap becomes deeper, central banks should conduct QE with sufficiently rapid pace of asset purchases; and (3) the combination of QE and FG yields synergy effects that strengthen the power to escape from the liquidity trap through mitigating precautionary saving motives.

JEL Classification
E21, E31, E52, E58

unconventional monetary policy; liquidity trap; uninsurable income uncertainty; incomplete market; quantitative easing; forward guidance

We would like to thank Kosuke Aoki, Hibiki Ichiue, Koji Nakamura, Shin-Ichi Nishiyama, Kenji Nishizaki, Shigenori Shiratsuka, Yaz Terajima, Yuki Teranishi, Kazuo Ueda, Kozo Ueda, participants at the 3rd BOC-BOJ Joint Workshop "Challenges to Central Bank Policies for Price Stability and Financial Stability," and colleagues at the Bank of Japan for their helpful comments. The opinions expressed here, as well as any remaining errors, are those of the authors and should not be ascribed to the Bank of Japan.

  1. *1Monetary Affairs Department, Bank of Japan
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  2. *2Monetary Affairs Department (currently Research and Statistics Department), Bank of Japan
    E-mail :


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