Bernanke’s No-Arbitrage Argument Revisited: Can Open Market Operations in Real Assets Eliminate the Liquidity Trap?

We first show that, at least in theory, open market operations in real assets can be a useful tool for overcoming a liquidity trap because they change the inflation incentives of the government, and thus change private sector expectations from deflationary to inflationary. We argue that this formalizes Ben Bernanke's arbitrage argument for why a central bank can always increase nominal demand, despite the zero lower bound. We illustrate this logic in a calibrated New Keynesian model assuming the government acts under discretion. Numerical experiments suggest, however, that the needed intervention is incredibly high, creating a serious limitation of this solution to the liquidity trap. Our experiments suggest that while asset purchases can be a helpful commitment device in theory, they may need to be combined in practice with fiscal policy coordination to achieve the desired outcome.(This abstract was borrowed from another version of this item.)