Liquidity trap

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The liquidity trap in Keynesian economics is a situation where monetary policy is unable to stimulate an economy, either through lowering interest rates or increasing the money supply.

Contents [hide] 1 Conceptual evolution 2 See also 3 References 4 Further reading

[edit] Conceptual evolution

In its original conception, a liquidity trap resulted when demand for money becomes infinitely elastic (i.e. where the demand curve for money is horizontal) so that further injections of money into the economy will not serve to further lower interest rates. Under the narrow version of Keynesian theory in which this arises, it is specified that monetary policy affects the economy only through its effect on interest rates. Thus, if an economy enters a liquidity trap, further increases in the money stock will fail to further lower interest rates and, therefore, fail to stimulate.
In the wake of the "Keynesian revolution" in the 1930s and 1940s, various neoclassical economists sought to minimize the concept of a liquidity trap by specifying conditions in which expansive monetary policy would affect the economy even if interest rates failed to decline. Don Patinkin and Lloyd Metzler specified the existence of a "Pigou effect," named after English economist Arthur Cecil Pigou, in which the stock of real money balances is an element of the aggregate demand function for goods, so that the money stock would directly affect the "IS" curve in an ISLM analysis, and monetary policy would thus be able to stimulate the economy even under the existence of a liquidity trap. While many economists had serious doubts about the existence or significance of this Pigou Effect, by the 1960s academic economists gave little credence to the concept of a liquidity trap.
The neoclassical economists asserted that, even in a liquidity trap, expansive monetary policy could still stimulate the economy via the direct effects of increased money stocks on aggregate demand. This was essentially the hope of the Bank of Japan in the 1990s, when it embarked upon quantitative easing. Similarly it was the hope of the central banks of the United States and Europe in 2008–2009, with their foray into quantitative easing. These policy initiatives tried to stimulate the economy through methods other than the reduction of short-term interest rates.
However, the concept returned to prominence in the 1990s when the Japanese economy fell into a period of prolonged stagnation despite the presence of near-zero interest rates.^[1] While the liquidity trap as formulated by Keynes refers to the existence of a horizontal demand curve for money at some positive level of interest rates, the liquidity trap invoked in the 1990s referred merely to the presence of zero interest rates (ZIRP), the assertion being that since interest rates could not fall below zero, monetary policy would prove impotent in those conditions, just as it was asserted to be in a proper exposition of a liquidity trap.
While this later conception differed from that asserted by Keynes, both views have in common first the assertion that monetary policy affects the economy only via interest rates, and second the conclusion that monetary policy cannot stimulate an economy in a liquidity trap.
Much the same furor has emerged in the United States and Europe in 2008–2010, as short-term policy rates for the various central banks have moved close to zero.^[2]

[edit] See also

• Capitol Hill Baby-Sitting Co-op
• Liquidity preference
• Lost Decade (Japan)
• Subprime mortgage crisis

[edit] References

1. ^ Sophia N. Antonopoulou, "The Global Financial Crisis," The International Journal of Inclusive Democracy, Vol. 5, No. 4 / Vol. 6, No. 1 (Autumn 2009 / Winter 2010).
2. ^ Paul Krugman, "How Much Of The World Is In a Liquidity Trap?," http://krugman.blogs.nytimes.com/ (17 March 2010).