The Risks of Deflation and the Effectiveness of Monetary Policy in the Euro Area *

There is little risk of deflation and a liquidity trap in the euro area. Inflation and short-and long-term inflation expectations are relatively close to 2% per year. With the current short nominal interest rate at 2%, there is ample room for more expansionary monetary policy if needed, and there is no reason to doubt the effectiveness of standard monetary policy in the euro area. Although temporary deflation in Germany cannot be excluded, there is no risk for prolonged deflation in Germany, since with a common currency German competitiveness would improve and stimulate exporting and import-competing sectors in Germany. In the very unlikely event of a liquidity trap in the euro area, in which case the effectiveness of standard monetary policy would be considerably weakened, my proposed Foolproof Way — with (1) a price-level target path, (2) a currency depreciation and a temporary crawling peg, and (3) an exit strategy in the form of a return to a float and normal monetary policy when the price-level target has been reached — can be used as an effective means to escape from the liquidity trap.