ECON430-Topic #2: Liquidity Traps (if they exist)

Paul Krugman is probably the loudest econo-pundit who frequently talks about liquidity traps, and has his own definition. The NY Fed has a short paper on liquidity traps as well. There are many theories about whether or not liquidity traps exist, and if they do, how do we get rid of them? There are other econo-bloggers who have their own ideas about how to escape from a liquidity trap.

Questions you might try to answer:

  • Krugman’s most important point gets to the issue of quantitative easing, as well as qualitative easing. What role do these types of unconventional monetary policy play today in our economy. How have they operated? Has quantitiative/qualitative easing helped the economy? Who has been the beneficiary of this unconventional policy?
  • Report on some evidence supporting the existence of liquidity traps, or lack thereof. If you believe that they have existed in the past, what are the most effective ways of dealing with these traps?

I would like your statements to be as subjective as possible, or in jargon terms, positive and not normative in nature. Also, remember, I want you to keep your descriptions short, basic, and related to classroom content. Read other students comments before posting, and please leave your name with your posting.

7 thoughts on “ECON430-Topic #2: Liquidity Traps (if they exist)”

  1. Despite the debate on the existence of liquidity traps, will the Fed be able to get get us out IF they do exist? Ultimately, the Fed's recent expanding and unorthodox policy action will prevent them from achieving that goal. The NY Fed article describes a liquidity trap as "situation in which the short-term nominal interest rate is zero [where] increasing money supply has no effect in a liquidity trap so that monetary policy is ineffective." They also go on to state that under modern conditions monetary policy is effective IF it is able to change future expectations. The Fed's ability to change future expectations is where the breakdown will occur. Even with the Fed releasing documents to increase transparency of their actions, most people cannot give an accurate predictions of what the Fed will do in the short term. Most people believe that in the near future the Fed is going to increase interest rates because of the obvious risk of inflation. With the money supply as large as it is and the Fed's balance sheets continuing to grow, there is no way interest rates are going to stay at their near zero levels. People's expectations are that interest rates will rise and the Fed is going to be unable to change those expectations. The same problem that made Japan's quantitative easing ineffectual during the 1990's will occur today if the Fed tries to use conventional Monetary Policy. Neil E. Powell

  2. Japanese economy recently experienced the liquidity trap. In late 1990s, Bank of Japan’s nominal short-term interest rate collapsed to zero. Their recession prolonged and experienced long economic stagnation and deflation. Japanese monetary authority increased its money supply to get out from the deflation and the recession. But apparently, the policy of quantitative easing was not very effective. According to Krugman, the most effective way of dealing the liquidity trap is that the “central bank would need to commit itself to the future monetary expansion and also communicate this commitment to the private sector.” If the central bank can influence private sector beliefs, shaking their expectations, the private sector will expect in future inflation, the real interest rate would fall and the economy will soon come out from recession and deflation.

  3. Quantitative easing has clearly played a big role in the economy today. The government, this year, bought 1 trillion dollars worth of long term bonds. This “Quantitative Easing” was used to try and get our interest rates up to their normal level. Up to this point, short term interest rates are remaining right around the zero level, so it doesn’t seem that this quantitative easing has worked so far. I don’t think enough time has passed to see the true effects of the policy though. Thus far no one seems to have benefited from our quantitative easing. Eggertson talked about Japan from 01-06, and it didn’t seem that this had the exact effect that was originally intended. The monetary base went up by 70% during these years, and this policy didn’t even really have any affect on output or prices. In my opinion liquidity traps exist, and we are currently in one now. Krugman states a liquidity trap is, “a situation in which conventional monetary policy — open-market purchases of short-term government debt — has lost effectiveness.” This is exactly what’s going on now. ST interest rates are basically at 0, and most conventionally monetary policy has lost effectiveness. Svensson talks about a fool proof way to get out of the liquidity trap by devaluing our currency. This seems like it would make sense, to increase expectations for a higher price level. The problem with this is that it seems to have too many other negative problems associated with it, such an increase of the real value of our government debt.

  4. The birth of the debate about liquidity traps was conceived out of the consequences of the Great Depression. During this time period short-term nominal interest rates were nearly zero so the economy could not be stimulated through this mechanism. Instead, as the NY Fed points out, FDR announced a policy of reflation, supported by other policies which included “massive deficit spending, higher real government spending, foreign exchange interventions, and even policies that reduced the natural level of output.” In the past two years the Fed has undertaken the same actions with the major examples being the 787 billion dollar stimulus package passed in February, the government takeover of Fannie Mae and Freddie Mac, the bailout of the insurance company AIG, as well as artificially holding the interest rates down at an attempt to spur output. Although not identical, I feel that the state of our current economy and the state of the economy after the Great Depression are similar enough to compare the effects of these unconventional methods of monetary policy. The main issue is these methods worked after the Great Depression. However, several decades later, under similar conditions, we find ourselves still searching for an economic antidote. As several articles and class discussions have indicated, much of the economic recovery is going to depend on people’s expectations. It appears that during FDR’s presidential terms, the policies were well communicated with the public and succeeded in altering the public’s expectations. This leads me to believe that the people today are unsure of the discretionary actions the Fed has been taking and their expectations will not be altered until the Fed begins communicating more clearly.

  5. As Richard Johnsson said in the liquidity-trap myth article, the idea Keynes propounded was that the relation between profits and investment was negative and ‘when some commentators put forward the liquidity trap as an explanation of the Japanese problems, they are implicitly assuming that there is a negative relation between the rate of profit and investment’ when it had a positive relation. Moreover, Johnsson said that Krugman had to change the investment to consumption to apply the liquidity trap to Japan, which was the exact opposite of investment. In the US, quantitative easing cannot be over until the nominal yield on all government securities of any and each maturity equals zero. In principle, quantitative easing can take place at any level of official policy rate and it does not need to wait until the zero rate is reached. The central bank should do more of quantitative and qualitative easing, which will expand the size of their balance sheets, mainly by increasing the monetary base on the liability side (by printing money) and the asset side should expand by increasing lending to the private sector secured against private securities and growing outright purchases of private securities. Nak Choi

  6. On the issue of whether or not quantitative/qualitative easing used by the Fed has helped to combat the financial crisis, in my opinion, these types of unconventional monetary policy have helped the economy. In his blog, Krugman claims that, “there’s a much stronger case for fiscal policy than in normal times, because we don’t know how well these unconventional measures will work.” However, in a 2004 paper, Ben Bernanke claims that quantitative easing may affect the economy through multiple channels and that “quantitative easing that is sufficiently aggressive and that is perceived to be long-lived may have expansionary fiscal effects.” Bernanke claims that so long as the central bank commits to not reversing its open market operations too soon after the crisis begins to turn around, these methods of quantitative easing will have similar effects to fiscal policy. Therefore, while Krugman claims that monetary policy is no longer effective and implies that fiscal policy is the only remedy for today’s economy, I believe the quantitative easing methods employed by Bernanke and the Fed will have a similar effect so long as the Fed commits to not reversing operations in the near future.

  7. Firstly, I would like to say that I believe liquidity traps are definitely real, according to Paul Krugman’s definition of it, and that the way Richard CB Johnsson manipulated the already dead IS/LM model in order to imply that Keynesians are “implicitly assuming that there is a negative relation between the rate of profit and investment” does not thoroughly defend his argument of the liquidity trap myth. Of course as potential profits from investments would increase, so would the actual amount of investments, Krugman never said that. Although Johnsson would not have been able to address the conditions of this current recession, the article was written in 2003, he does not take into consideration how this Japanese recession would have affected the behavior of consumers. Knowing that you are in a recession doesn’t make the average investor start doling out funds to help jump start it unless there is a way to make growth of these idle funds. Although, according to his data, he was correct in illustrating that growth in potential profits led to increases in actual investment, the overall message from this is that this use of monetary policy still did not get Japan out of this slump for over a decade.Y-Van Truong

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