Wednesday, September 7, 2011

This thing called a liquidity trap

Paul Krugman has stated that the United States economy is currently in a liquidity trap.  I am inclined to agree, but not just because he won the Nobel Prize in Economics in 2008.  In his column with the New York Times and his blog, he has laid out explanations of the liquidity trap which the United States faces.  For illustration, see the following graph:

Nominal Interest Rate v. Output (IS/LM)

This is a representation of the Keynesian IS/LM model.  The model was first developed by John R. Hicks during the 1930s.  The pinkish line is essentially a supply curve for savings and the blue line is the demand for savings.  In normal times, the intersection of the two curves is above a 0% nominal interest rate.  In such a situation, the Federal Reserve can affect the level of output by increasing or decreasing the supply of money, thus shifting the supply curve.  In the special case of the liquidity trap, the intersection of the two curves is below a 0% nominal interest rate, so that the level of output is determined by the intersection of the demand curve with the "zero lower bound", in other words, the point of demand at 0% nominal interest.  Below the zero lower bound, the Federal Reserve is not able to affect the level of output by monetary policy.  This means that the economy will operate under its potential output.

And this is where we are.  The economy is depressed, many more people want a job than are able to get one and the Federal Reserve is unable to do much, if anything, about it.  There is a little bit of controversy about how powerless the Federal Reserve actually is.  For example, Krugman and Rogoff have suggested that if people and businesses can be convinced that the Federal Reserve will support a higher level of inflation, it may affect peoples' expectations and help bring about recovery.  There are still others who have argued that there may still be capacity to affect output if the Federal Reserve undertakes unconventional lending policies, like what has been called "quantitative easing."  Nevertheless, traditional monetary policy is unlikely to bring about a quick recovery to trend output.


  1. It's worth noting that Krugman's liquidity trap is not in the General Theory. Keynes's liquidity trap is an entirely different scenario from what modern Keynesians think the liquidity trap.

    For Krugman, a liquidity trap is as you have described. For Keynes, a liquidity trap is when an increase in the quantity of money cannot reduce the yield on long-term government bonds.

    As Leijonhuvud put it, there is Keynesian economics and then there is the economics of Keynes!

    1. There the same thing, people hold cash instead of bonds at 0% interest rate, and thus there is not enough spending.

    2. I disagree, I think that the main thing holding banks from lending right now is capital ratios, looking at reserves at the FED is largely irrelevant now a days (what is money????). Banks at the moment are not able to lend. Also, although the risk free rate is low, credit spreads are much higher due to low expectations. Really, we need a $300 billion capital injection into the banking system, creating 15 banks at $20 billion of equity each. Also, I think some assets remain grossly over valued.

  2. I think it's interesting that this piece still draws some interest. I feel more equivocal about things now, but I think the liquidity trap points us to the basics of the situation we are currently in. Keep in mind that if people expect higher inflation, then the real interest rate at the zero lower bound will decline, which implies that not all actions vis-a-vis monetary policy need be impotent. When it comes down to it, though, if there's a backlog of work the government should have done (invest in infrastructure, etc.), then there's less reason to argue against fiscal stimulus aimed at such deficiencies.