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Foreign Exchange and the Liquidity Trap

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When short-term interest rates hover near zero, central banks may have difficulty offsetting downward momentum on prices and economic activity through traditional monetary policy channels, since commercial banks have little incentive to make loans. Economists refer to this situation as a liquidity trap. Do exchange rate targets and foreign exchange operations, as some have suggested, offer a way to escape such a trap?

When short-term interest rates hover near zero, central banks may have difficulty offsetting downward momentum on prices and economic activity through traditional monetary policy channels, since commercial banks have little incentive to make loans. Economists refer to this situation as a liquidity trap. Do exchange rate targets and foreign exchange operations, as some have suggested, offer a way to escape such a trap?


Suggested citation: Humpage, Owen F., and William R. Melick, 2003. "Foreign Exchange and the Liquidity Trap," Federal Reserve Bank of Cleveland, Economic Commentary, 10.01.2003.

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