Liquidity trap and optimal monetary policy: Evaluations for U.S. monetary policy from 2020 to 2023

Abstract

This paper shows that the recent Fed’s exit strategy reflects the conduct of optimal monetary policy in a liquidity trap. We use the conventional new Keynesian model for the U.S economy, incorporating recent inflation persistence. As observed in the Fed’s liftoff policy, optimal monetary policy shows inflation overshooting and prolonged zero interest rate policy under high inflation beyond the 2 percent target. With greater persistence of inflation, inflation overshooting becomes larger, yielding better consistency with the data. Our analysis also indicates the presence of a forward guidance puzzle in the Fed’s exit policy. Under optimal monetary policy, the discounted Euler equation successfully dampens forward guidance effects and better describes the output gap.