Liquidity Trap

10 Key excerpts on "Liquidity Trap"

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  The Handbook of Post Crisis Financial Modelling

  • Emmanuel Haven, Philip Molyneux, John Wilson, Sergei Fedotov, Meryem Duygun, Emmanuel Haven, Philip Molyneux, John Wilson, Sergei Fedotov, Meryem Duygun(Authors)
  • 2016(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  4 Strategic Monetary and Fiscal Policy Interaction in a Liquidity Trap

  Ali al-Nowaihi and Sanjit Dhami

  1   Introduction

  In its classical form, the Liquidity Trap, a term coined by Keynes (1936), is a situation where an increase in money supply fails to reduce the nominal interest rate. The modern literature has concentrated on the case where the nominal interest rate has been driven down to zero (the so called ‘zero bound’). The source of a Liquidity Trap, in most circumstances, is a sharp fall in aggregate demand; see Keynes (1936), Bernanke (2002). Interest in the Liquidity Trap has revived in recent years due, in no small measure, to the experience of Japan since 1990. Woodford (2005, 29) discusses the near miss of the US economy from a Liquidity Trap in the summer of 2003. The era of successful delegation of monetary policy to independent central banks with low inflation targets1 opens up the possibility that sufficiently large negative demand shocks might push an economy into a Liquidity Trap with huge associated welfare consequences.2 Blanchard et al. (2010) propose an inflation target of 4 percent in order to provide greater range for the nominal interest rate instrument. Our paper provides one framework within which to evaluate this proposal.

  In a Liquidity Trap traditional monetary policy loses its effectiveness because nominal interest rates can be reduced no further in order to boost the interest sensitive components of aggregate demand. Hence, reliance must be placed on other, possibly more expensive, policies. Keynes (1936), in the first policy prescription for a Liquidity Trap, suggested the use of fiscal policy, which works through the multiplier effect to boost output and employment.

  However, the recent literature has largely focussed on monetary policy and the role of expectations. Krugman (1998, 1999) reformulated the Liquidity Trap as a situation where an economy requires a negative real interest rate. With nominal interest rates bound below by zero, the only way in which a negative real interest rate can be achieved is to have an expectation of positive inflation.3

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  New Perspectives on Political Economy and Its History

  • Maria Cristina Marcuzzo, Ghislain Deleplace, Paolo Paesani, Maria Cristina Marcuzzo, Ghislain Deleplace, Paolo Paesani(Authors)
  • 2020(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  and Robertson between 1936 and 1940, where the expression was coined. From our investigation, we may draw the following provisional conclusions.

  The concept of a ‘Liquidity Trap ’ is a discovery made by Robertson: meditating on the GT , he captures with the metaphor of the trap the possibility that money hoarding may represent an obstacle to a fall in the interest rate. Robertson’s attention is caught by the possibility that the beneficial effects of saving, or of monetary expansion, can be offset by the accumulation of idle balances.

  However, having admitted this possibility, Robertson tends to attribute minor importance to it. He remains ultimately convinced, on the basis of his own theory, that counterforces will be activated so as to overcome this block and restore the natural interest rate. He therefore tends to downplay the practical relevance of the Liquidity Trap as an explanation of persistent economic depression.

  Keynes , on the contrary, even though he had barely touched upon the inefficacy of monetary policy in the GT , is stimulated by Robertson’s remarks on the possibility that liquidity could play the role of a chronic obstacle to full employment and eventually appears to have recognized the relevance of this case, emphasizing the importance of the propensity to hoard in holding the interest rate at a level that is not compatible with full employment. In particular, it is only upon reading Robertson’s review that Keynes becomes aware of the fact that not only is uncertainty about the future interest rate the necessary condition for the existence of the liquidity preference (as he had written in Keynes [1936 ] 1973 , p. 168), but that the degree of uncertainty about the future, i.e. the lack of confidence in formulating expectations, is a major determinant of the level of the interest rate (as he would state explicitly only in Keynes 1937a , p. 216).

  However, even when Keynes eventually acknowledged the importance of the point raised by Robertson for his theory of the interest rate as ‘barometer of the degree of our distrust of our own calculations and conventions concerning the future’ (Keynes 1937a , p. 216), he did not pick up the expression ‘Liquidity Trap

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  David Laidler's Contributions to Economics

  • R. Leeson(Author)
  • 2010(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Recall that the characteristic of a Hawtreyan credit deadlock is that it prevents money being created, whereas a Keynesian Liquidity Trap suggests that even if money is created this would do no good by itself. But with interest rates falling to very low levels, many observers have concluded that the economy had fallen into a Liquidity Trap. For example, Paul Krugman (1999, 2) argued that if, as was happening in Japan, ‘the interest rate is zero, bonds and money become in effect equivalent assets; so conventional monetary policy, in which money is swapped for bonds via open-market operation, changes nothing’; and ‘once it became clear that the Bank of Japan really did consider itself unable to increase demand in an economy that badly needed it, it also became clear . . . that the theory of the Liquidity Trap needed a fresh, hard look’. He stressed that this trap ‘is in a funda- mental sense an expectational issue. Monetary expansion is irrelevant [to effect- ive demand] because the private sector does not expect it to be sustained.’ 28 His 358 Roger J. Sandilands solution: influence inflationary expectations through an unconventional and credible commitment that the BoJ would uncompromisingly pursue a 15-year inflation target of 4 per cent in order to reduce the expected real interest rate to below zero (the postulated ‘natural’ rate if prices were perfectly flexible) to stimu- late investment and escape the Liquidity Trap. Kazuo Ueda (2005) suggests that Krugman’s focus on the need to manipulate inflationary expectations was consistent with the BoJ’s explicit commitment to an effectively zero (short-term) interest rate policy from early 1999 until such time as signs of inflation should appear, even when the Taylor rule might indicate the need to raise it. But when the economy did show signs of recovery (though with prices still falling) the overnight call rate was raised to 0.25 per cent in August 2000.

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  Law and Macroeconomics

  Legal Remedies to Recessions

  • Yair Listokin(Author)
  • 2019(Publication Date)
  • Harvard University Press

    (Publisher)

  74 ■ LAW AND MACROECONOMICS recessions described in the previous chapters. In this section, I explore ac-counts of prolonged recessions based on Liquidity Traps, secular stagnation, and the debt supercycle. These are related, differing in points of emphasis but not in their causal diagnosis: persistently weak aggregate demand underlies prolonged recessions. Most macroeconomists subscribe to a com-bination of the three accounts, each of which has implications for law and macroeconomics. Liquidity Traps Liquidity Traps begin with a sharp decrease in aggregate demand. In many cases, including the Great Recession, a financial crisis is the trigger. 7 A li-quidity trap, however, is more than just a drop in demand. Alone, even a large drop shouldn’t cause deep recessions, because when demand falls far short of capacity, savings become plentiful and interest rates decrease in re-sponse. Lower interest rates tempt potential spenders to buy more and savers to save less. Demand ultimately recovers and so does output and em-ployment. Expansionary monetary policy, raising the money supply to lower interest rates, hastens this fall in interest rates and subsequent recovery. Liquidity Traps emerge when very low interest rates persist. The Great Recession is emblematic. At the beginning of the Great Recession, short- term interest rates fell to zero; they were pinned there for the better part of a decade in most of the Group of 7 (G7) club of large industrialized democ-racies (see Figure 4.3). Long-term interest rates also fell to historically low rates, with ten-year government bond yields falling below 2 percent per year in each G7 country. (Long-term rates need to be above short-term rates to compensate savers for the additional risk associated with locking in savings at low rates over an extended period.) In a Liquidity Trap, the zero lower bound on interest rates impedes the usual macroeconomic adjustment process.

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  Economy of Words

  Communicative Imperatives in Central Banks

  • Douglas R. Holmes(Author)
  • 2013(Publication Date)
  • University of Chicago Press

    (Publisher)

  CHAPTER NINE Liquidity-Trap Economics

  If the interest rate is zero, bonds and money become in effect equivalent assets; so conventional monetary policy, in which money is swapped for bonds via an open-market operation, changes nothing.—Paul Krugman

  In late spring 2009 the financial crisis was taking a decisive turn. The banking crisis had stabilized, although the leadership of the Riksbank was still apprehensive about the banking system in the Baltic states that posed particular problems for the major Swedish banks. Governor Stefan Ingves summarized the situation:

  Since the previous meeting there had been a widespread downward revision to forecasts of economic activity abroad. The Riksbank is now expecting to see the weakest economic activity during peacetime since the Great Depression of the 1930s. The crisis was triggered by a turnaround in the credit cycle after a period of growing financial and global imbalances. What was initially described as an essentially financial crisis has now developed into a general, global, macro economic crisis but with remaining severe problems in the financial markets. (Sveriges Riksbank 2009b)

  Anders Vredin, director of monetary policy, noted:

  The gloomy international developments together with the surprisingly weak GDP outcome for the fourth quarter of 2008 mean that growth in Sweden this year has been revised down by 2.9 percentage points, to minus 4.5 per cent. Growth is also expected to be low in 2010 and unemployment is expected to rise to 11 per cent towards the end of 2010. In total, this development means that resource utilisation will be low throughout the entire forecast period. (Sveriges Riksbank 2009b)

  As in the Great Depression, the global threat was the collapse of the aggregate demand sustaining the real economy. With great speed in the fall of 2008, the major economic powers, notably China and the United States, enacted massive stimulus programs, in the spirit of Keynes, to stem the decline in consumption and trade and thus stabilize the real economy.

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  Macroeconomic Analysis in the Classical Tradition

  The Impediments Of Keynes's Influence

  • James C W Ahiakpor(Author)
  • 2021(Publication Date)
  • Routledge

    (Publisher)

  Treatise , Keynes defines investment as “the increased production of material wealth in the shape of capital-goods” (1930, 2: 207). Hawtrey (1950: 43) appropriately contrasts Keynes’s definition with its ordinary meaning: “acquisition of income-yielding securities or property, not Keynes’s sense of the accumulation of capital assets and unconsumed goods.” Keynes’s definition of investment is one reason he failed to appreciate the validity of the classical explanation that the supply of savings (demand for income-yielding securities) and investment-demand (supply of income-yielding securities) determine interest rates (inverse of the price of income-yielding securities). Besides, the funds employed in production (investment) include the classical wages fund and cash-on-hand, or “circulating capital.”

  13 Boianovsky (2004: 93) thus credits Hicks (1937) with too much originality with his claim that “Hicks based his formulation of the Liquidity Trap on the notion that the short-run nominal interest rate cannot be negative.”

  14 Keynes’s reference to debts of “long term” justifies Hicks’s explanation that Keynes always had the long-term rate of interest in mind in the liquidity-trap proposition. Current discussions of the Liquidity Trap in term of the US Fed’s operating in an environment of a zero lower bound of short-term rates and Boianovsky (2004) cited above thus appear to be inconsistent with Keynes’s own proposition.

  15 As Hawtrey (1933: 140) notes, “The currency in circulation in the United States rose [about one billion] from $4,598,000,000 in February, 1931, to $5,627,000,000 in February, 1932, while the depression was rapidly growing worse and the price level falling.” During this period three-month US Treasury bill rates actually rose: from 1.21% in February 1931 to 3.25% in December before falling to 2.65% in February 1932. The rate thereafter declined sharply to its lowest level of 0.08% in December 1932, rising again to 2.29% by March 1933 before declining to 0.10% in September. It rose to 0.69% in December 1933; see Table 8.1.

  16

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  Playing Monopoly with the Devil

  Dollarization and Domestic Currencies in Developing Countries

  • Manuel Hinds(Author)
  • 2008(Publication Date)
  • Yale University Press

    (Publisher)

  The only way they can shift the relative price of the two currencies is to make their own scarce by stopping its creation. This is ironic because many people believe that the ability to print local currencies is useful to resolve crises in those countries. The two versions of the Liquidity Trap also diverge in terms of their likely frequency. In the developed countries, the Liquidity Trap is a rare occurrence, the result of relatively rare qualitative changes in behavior, while it is endemic in the developing ones. Of course, people in both kinds of countries always tend to cling to a certain amount of liquidity for transaction and precautionary purposes. Such amount is a function of the probabilities of needing different amounts of liquid resources at any given moment in the near future and the costs of transforming illiquid assets into liquid forms. Financial development tends to reduce the demand for strictly liquid assets (currency bills and coins), as payments can be realized through checks and credit or debit cards, or electronically, debiting accounts kept in a less liquid form. Yet, they always prefer to keep liquid a certain portion of their resources, and this is normal. The problem begins when people start demanding money for speculative purposes—that is, because they believe that money will appreciate relative to all other assets in the economy. This is what can effectively lead to a downward spiral in economic activity. This happens only in quite special circumstances in developed countries. However, it happens endemically in developing ones, where the speculative motive to hold money is always there, but associated with an international currency. It is endemic because the possibility of incur-ring in capital losses by holding the local currency is not a risk but a certainty in countries where the currency sinks continuously.

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  Monetary Policy with Very Low Inflation in the Pacific Rim

  • Takatoshi Ito, Andrew K. Rose, Takatoshi Ito, Andrew K. Rose(Authors)
  • 2007(Publication Date)
  • University of Chicago Press

    (Publisher)

  The first of these consists of theoretical analyses of the policy issues raised by deflation and the zero lower bound. These issues include the causes and implications of a Liquidity Trap, and the role (if any) of foreign exchange or asset-market interventions in escaping from such a trap (see, for example, Svensson 2001 and McCallum 2000). They also en-compass the costs and benefits of coordinated fiscal and monetary-policy actions, such as “helicopter drops” (Bernanke 2000), or of other more ab-stract policy options such as Gesell taxes on money balances (Goodfriend 2000), designed to extricate an economy from deflation. Finally, they also include the role (if any) of the choice of monetary-policy regime—and in particular the decision whether or not to adopt a price-level or inflation tar-get—in also helping an economy to escape from deflation (Krugman 1998). Monetary Policy, Asset-price Bubbles, and the Zero Lower Bound 73 28. For the two opposing views in this debate see Bernanke and Gertler (2001) and Cec-chetti, Genberg, Lipsky, and Wadhwani (2000). The second stream consists of empirical or historical examinations of these same issues. Such examinations have primarily focused on the expe-riences of Japan since the early 1990s (see, for example, Posen 2003 and Fukao 2003), but also include reexaminations of other relevant episodes, such as the attempt by U.S. authorities in the 1960s to increase liquidity, and lower long-term bond rates, through “Operation Twist” (see Modigli-ani and Sutch 1966). 29 As noted earlier, this chapter lies at the overlap between the two broad research areas just described. From this viewpoint, the asset-price bubbles in this chapter may be regarded, at one level, as just one particular source of shocks with the potential—especially if inflation is being held at too low a level prior to such a shock—to drive the economy to a state where the zero lower bound becomes a constraint on policy.

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  Macroeconomics For Dummies

  • Dan Richards, Manzur Rashid, Peter Antonioni(Authors)
  • 2016(Publication Date)
  • For Dummies

    (Publisher)

  This problem occurs when the nominal interest rate is at or near zero, because the opportunity cost of holding cash is now nil. When you can’t earn a return on your funds anyway, you may as well hold them in cash. After all, cash is the most liquid of all assets, and when the nominal interest rate is zero, you can’t do better than cash anyway.

  In Figure 14-6 , the money supply is initially represented by m 0 , and the equilibrium nominal interest rate is already at approximately zero. (Between the end of 2008 and the end of 2015, the federal funds rate stayed consistently in the range of 0 to 0.25 percent.) In this case, increasing the money supply further to m 1 , say by open market operations, has no impact on the interest rate, because people are willing to hold unlimited cash if the nominal interest rate is essentially zero. Compare this to the situation in Figure 14-1 , where an increase in the money supply does result in a fall in the interest rate when there is no Liquidity Trap.

  © John Wiley & Sons, Inc.

  FIGURE 14-6: In a Liquidity Trap, increasing the money supply from m 0 to m 1 won’t lower the interest rate. It will stay at i 0 .

  Here’s another way of thinking about this situation: If nominal interest rates are below zero, that is, negative, and you give someone $10, sometime later he’d give you back less than $10. In other words, you’d be paying him for lending him money, which is crazy. You’d do better putting your cash under a mattress. So, once the nominal rate hits zero or near zero, it’s hard to see how it can go much lower.

  If you follow the news closely, you may smell a rat here. Highly unusually, recent years have seen a few cases where the nominal interest rate (yield) on some government bonds has been slightly negative. There are two reasons for these exceptions to the general rule. First, in the wake of repeated financial turmoil over recent years, banks have been holding a lot of excess reserves. In an effort to get banks to lend out those reserves instead and create loans that finance economic activity, some central banks have started to penalize such extra reserves by charging banks for holding them — by paying a negative return on reserves held at the central bank. For these banks, then, buying bonds that pay less than zero interest might still be better than holding their funds as reserves. An interest rate of minus 0.1 percent is still better than one of minus 0.2 percent.

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  Money and Markets

  A Doctrinal Approach

  • Maria Cristina Marcuzzo, Alberto Giacomin, Maria Cristina Marcuzzo, Alberto Giacomin(Authors)
  • 2007(Publication Date)
  • Routledge

    (Publisher)

  If . . . money-wages were to fall without limit whenever there was a tendency for less than full employment . . . there would be no resting place below full employment until either the rate of interest was incapable of falling further or wages were zero.

  (ibid.: 304)

  Keynes’s analysis of the deflationary process is, thus, open-end in character. Whether wages become zero before or after the rate of interest has reached its lower limit – or whether they stop falling before having become zero because full employment is somehow established – will depend on exactly how liquidity preference and the inducement to invest (and to consume) are affected by deflation. And this, in Keynes’s opinion, is a matter on which no general rules can be laid down.

  ‘A world of difference’

  In order to turn the lower limit to the rate of interest – the ‘Liquidity Trap’, as it is so often called9 – into the only obstacle capable of preventing money-wage flexibility from securing full employment, two steps are required. The first step consists in removing all the obstacles other than the above limit that may prevent a rise in the quantity of money from forcing down the rate of interest. This is done by assuming away the disturbing effects of unanimity of expectations (for all rates of interest higher than the minimum one) and making liquidity preference independent of any change that may occur in the quantity of money. The nature and purport of this step will be easily grasped by comparing the difficulties Keynes envisages the monetary authorities encountering in their attempt to force down the rate of interest, described above, with the fairly automatic consequences of a rise in the quantity of money made possible by the perfectly stable, mainly risk-based liquidity-preference function contemplated in Hicks (1937) or Modigliani (1944).

  The second step consists in treating a fall in money wages and prices as perfectly equivalent to a rise in the quantity of money. According to Modigliani’s well-known formulation, unemployment results from

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