Role of Expectations in a Liquidity Trap

A number of previous studies suggest that inflation expectations are important in
considering the effectiveness of monetary policy in a liquidity trap. However, the role of
inflation expectations can be very different, depending on the type of monetary policy
that a central bank implements. This paper reveals how a private agent forms inflation
expectation affects the effectiveness of monetary policy under the optimal commitment
policy, the Taylor rule, and a simple rule with price-level targeting. We examine two
expectation formations: (i) different degrees of anchoring, and (ii) different degrees of
forward-lookingness. We show that how to form inflation expectations is less relevant
when a central bank implements the optimal commitment policy, while it is critical when
the central bank adopts the Taylor rule or a simple rule with price-level targeting. Even
for the Japanese economy, the effects of monetary policy on economic dynamics
significantly change according to expectation formations under rules other than the
optimal commitment policy.