Could an Active Monetary Policy Create a Liquidity Trap?
John Taylor’s seminal 1993 paper illustrated how US monetary policy could be described by an interest rate feedback rule, whereby the short-term interest rate is set as an increasing function of both inflation and output. An extensive literature has since developed that explores the efficiency and dynamic properties of such feedback rules, with particular attention being paid to their supposedly stabilizing properties. The central policy recommendation that has emerged from this literature is that monetary authorities should conduct an ‘active’ monetary policy, in the sense that they should increase the nominal interest rate by more than one-for-one when the inflation rate increases. These active interest rate feedback rules have come to be known as Taylor rules and, given the amount of controversy that usually surrounds macroeconomic policy, the degree of consensus that has emerged regarding their desirability is remarkable. Subsequent empirical studies have confirmed that Taylor rule