Paul Krugman presents a simple formal model of a liquidity trap. He shows that monetary policy won't work, but fiscal policy can work, to bring the economy to full-employment.
Actually, that's not right. What his model shows is that current monetary policy won't work (because the nominal interest rate is at zero); but future monetary policy will be very effective in his model. A (permanent) 10% (say) increase in the future money supply in his model will cause a (permanent) 10% increase in the future price level, and this will cause current real interest rates to be minus 10%, which should be enough to get the economy back to full employment.
Krugman knows this, of course. It's not a new point. The question is: how can a central bank change future monetary policy today? How can a central bank change people's current expectations about future monetary policy and price levels? The biggest failure of current monetary policy is not what central banks are doing today; it is that they are failing to guide expectations about what they will do tomorrow.
I have read enough comments at various blogs to know that people's expectations of the future US price level are all over the map. Some (deflationists) expect future prices to be lower than today's; others (inflationists) expect future prices to be much higher than today's. There is no anchor. Anybody could be right.
The US Fed offers no guidance on expectations about future price levels. At least, I haven't heard any, and it should be offering guidance loud enough and clear enough that everyone should hear it. The Bank of Canada does offer some guidance: it remains committed to its 2% inflation target.
For a central bank in a liquidity trap, formal commitment to a 2% inflation target would give some help. But formal commitment to a price-level path rising at 2% per year would be better.
Readers who already understand the difference can skip this paragraph. If a central bank controls inflation perfectly, there's no difference between targeting 2% inflation and targeting a 2% price-level path. In both cases the price levels grows: 100, 102, 104, 106, etc. (I can't be bothered to do the compounding). But central banks can't control inflation perfectly. If an inflation targeting central bank makes a mistake in one year (only), the price level will go: 100, 101, 103, 105. If a price-level path targeting central bank makes the same mistake, the price level will go: 100, 101, 104, 106.
Both inflation targeting and price-level path targeting central banks will be driven off course during a liquidity trap. We don't know how long the liquidity trap will last, and we don't know how much deflation there will be while we are in the liquidity trap. With inflation targeting, all we know is that inflation will eventually return to 2%, but that the price-level will be permanently lower, by an unknown amount. With price level path targeting we know that there will be no permanent effect on the price level, and that the longer the liquidity trap lasts, and the worse the deflation, the higher the rate of inflation will eventually be to get us back on target.
It's that last bit, in bold, which shows the benefits of price-level path targeting. Expected inflation is the medicine for a liquidity trap, because it can make real interest rates negative even when nominal interest rates cannot be. Price-level path targeting is a regime in which the medicinal dose gets bigger as the disease gets worse.
Canada is not yet in a liquidity trap. The decision on whether to continue with inflation targeting or switch to price level path targeting will be made in 2011. Perhaps that's soon enough; perhaps not. In any case, the Bank of Canada's actual policy looks very close to price level path targeting.
The US is in a liquidity trap. The Fed does not even have formal inflation targeting to provide some sort of anchor for expectations of future price levels, and it shows. There is a strong argument for Ben Bernanke to announce a target time path for the future US price-level, even if he needs to admit his uncertainty about how long it will take to get onto that path. As long as people believe he will eventually get onto the path, the announcement will work.
Current fiscal policy is getting all the attention; future monetary policy is being ignored.