Notes on the Liquidity Trap

Notes on the Liquidity Trap∗

Fiona Maclachlan Department of Economics and Finance

Manhattan College Riverdale NY 10471

[email protected]

March 2004

∗ Prepared for presentation at the International Studies Association annual convention in Montreal, Canada, March 2004.

Notes on the Liquidity Trap Draft: 15mar04

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Increased integration of the world’s financial markets has created a greater

potential for macroeconomic instability arising from problems in the financial sector.

The extent to which financial disturbances can be amplified and distributed in the current

era of well integrated financial markets became strikingly apparent during the Asian

crisis of the late 1990’s, to cite just one example. A liquidity trap is one particular form

of financial difficulty in which a country may find itself. Many observers believe that

Japan’s recent economic difficulties arose from a liquidity trap. Japan’s experience has

led to discussion among economic analysts about the nature of the problem and about the

question of whether the same type of problem could crop up in other parts of the globe.

This paper explores the topic through addressing several open issues pertaining to

liquidity traps. We address, in turn, how liquidity traps can be classified, identified,

analyzed, and remedied. We find that previous analyses of the liquidity trap suffer from

limitations derived from the highly restrictive nature of the models that are used to study

them. We argue that a non-equilibrium theory that takes full account of uncertainty is a

more promising line of approach to analyzing the problem.

I. Classification

The term liquidity trap is used in a variety of ways and the danger is that a dispute

that purports to be about theoretical or empirical issues may turn out to hinge on a

semantic confusion. For this reason, it is important to classify and carefully distinguish

between different usages.

On the broadest definition, a liquidity trap is a situation in which monetary policy

provides no stimulus to economic activity. The potential for monetary policy to be

ineffective was recognized widely during the Great Depression. For instance, in a letter


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dated November 20, 1933 and signed by ten Oxford economists, F. D. Roosevelt is urged

to pursue an easy money policy but is warned that under certain circumstances open

market purchases of even long term bonds may not be an effective stimulus: “It will be

ineffective if there is no confidence in the future course of prices and also if there is so

much an excess of productive capacity in the form of capital plant already existing, that

the demand for new capital plant cannot be much expanded by a low interest rate.”

(Harrod et al. 1933)

At about the same time, the famous phrase, often associated with a liquidity trap,

“pushing on a string” was coined. Then Governor of the Federal Reserve Board,

Marriner Eccles, was testifying before Congress explaining that if expansionary open

market operations were performed, the reserves that would be created would lie idle in

the banks and do nothing to stimulate economic activity. Allan Meltzer (Clement 2003,

11) reports that “one of the congressmen said to him, what you’ve described is just like

pushing on a string. And he said, yes, yes, that’s it. Pushing on a string. You can pull on

a string, but you can’t push on a string.” The picture painted by the Oxford economists

and Eccles is similar. The Oxford economists emphasize the reasons why firms might

not demand, or be able to get, loans at even low interest rates, and Eccles notes the

resulting accumulation of reserves in banks when loans are not made.

Many writers, especially in the financial press, cite J. M. Keynes as the originator

of the term “liquidity trap.” Others more familiar with Keynes’ work realize he never

used the term but give him credit for coming up with the concept. The passage that is

cited is in the General Theory (1963, 207) :

There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually


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absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in the future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test.

The situation that Keynes describes involves more than just the ineffectiveness of

monetary policy. He is describing a situation in which monetary policy is ineffective

because the long-term interest rate on government bonds cannot be pushed down further.

The theory is that once the long-term rate of interest goes low enough, investors think it

has only one way to go, and that is up. Speculating that the interest rate will rise

motivates investors to hold money. In a Keynesian liquidity trap, the central monetary

authority cannot raise the price of bonds (and lower their yield) through open market

purchases because investors are willing to give up their bonds for cash without any price

increase.

J. R. Hicks (1937) formalized Keynes’ theory with the IS-LM model and

represented the liquidity trap with a horizontal portion of the LM curve. This portion of

the curve corresponds to a demand for money in terms of bonds that is perfectly elastic.

The idea is that an infinitesimal change in the interest rate will lead to a large change in

the quantity of cash demanded. It is not clear, however, whether the idea of a perfectly

elastic demand for money is implicit in Keynes' description of a liquidity trap. While it is

true that he thought a small downward movement in the interest rate would cause a large

shift into cash, it does not follow that a symmetric effect would take place with a small

upward movement of the interest rate. The supply and demand apparatus that Hicks

employs arguably packs more into the notion of a liquidity trap than is found in Keynes

verbal description.


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Keynes explicitly says that he knew of no real world example of the type of

liquidity trap he describes: “I know of no example of it hitherto” (1963, 207). But some

writers, for example David Laidler (1999, 258-259), believe that Keynes was ambiguous

about the empirical relevance of his liquidity trap. Laidler points to Keynes remarks

about a “crisis of liquidation” in the U.S. in 1932 when savers could not be persuaded to

part with money at any price, as evidence that Keynes did indeed think that a liquidity

trap had existed.

… whilst in the United States at certain dates in 1932 there was a crisis of the opposite kind—a financial crisis or crisis of liquidation, when scarcely anyone could be induced to part with holding of money on any reasonable terms. (1963: 207-208)

Keynes remarks here suggest not a perfectly elastic demand for money, but a

perfectly inelastic demand. He is saying that even at high rates of interest, investors

continued to hold on to money. The confusion about Keynes’ appraisal of the situation in

the 1930’s is due to the limitations of the demand for money construction. A flat demand

curve implies whether the interest rate goes up or down the change in demand for money

will be great: the response is symmetric. Keynes’ position was that if the interest rate

goes down a small amount investors will hold much larger money balances, but if the

interest rate goes up a small amount, they will not decrease their money balances. To

properly model a Keynesian liquidity trap, one has to take into account the asymmetry. If

the central bank were to start selling bonds could they bring down their price and raise

the yield, at a time when buying does not increase the price. Investors are willing to give

up their bonds for cash. But to get them to buy bonds the price has to be reduced.


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Hicks’ definition of the liquidity trap is the one that is most commonly employed

by economists in the macroeconomics literature. Recently, however, a variant of the

Hicksian liquidity trap has appeared. The variant puts focus on the short-term rate of

interest and says that a liquidity trap occurs when short-term securities are deemed to be

perfect substitutes for money. Paul Krugman (1998, 137), for example, defines the

liquidity trap as “that awkward condition in which monetary policy loses its grip because

the nominal interest rate is essentially zero” and cites the Japanese experience as an

example. Since long-term rates of interest never fell to zero in Japan and expansionary

monetary policy was conducted by open purchases of short-term securities, we can infer

that he was referring to the short-term rate of interest. Federal Reserve Board Governor

Ben Bernanke (2002, 5) appears to be referring to the modern variant of the liquidity trap

when he says: “As I have mentioned, some observers have concluded that when the

central bank’s policy rate falls to zero—its practical minimum—monetary policy loses its

ability to further stimulate aggregate demand and the economy.”

If one believes there is a fixed relationship between the short-term rate of interest

and the long-term rate, then the Hicksian liquidity trap and the modern variant amount to

the same thing. A fixed relationship implies a theory of term structure that says there is

an exogenously determined liquidity premium fixing the spread between long-term and

short-term securities.

In sum there are at least four different definitions of the liquidity trap that can be

distinguished and labeled with the names of economists who have suggested them:

1. The Eccles liquidity trap is a situation in which expansionary open

markets lead to an accumulation of excess reserves in the banks. The


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reason for the excess reserves is that, even at a lower interest rate, if the

economy’s prospects are grim, firms may not wish to expand and banks

may not wish to take on the default risk of lending.

2. The Keynes liquidity trap is a situation in which investors are ready,

with very little price inducement, to substitute long-term bonds with

cash. The reason is that they believe bond prices have reached a peak

(implying that they believe long-term interest rates have reached a

minimum). But there is nothing in the Keynesian liquidity trap that

says open market sales cannot succeed in lowering bond prices

(increasing yields).

3. The Hicks liquidity trap is based in his IS-LM model. It says that at

low rates of interest, the demand for money can be perfectly elastic, or

that money and long-term bonds are perfect substitutes. The Hicksian

liquidity trap implies that if the central monetary authority were to

attempt to raise the interest rate through open market sales, they would

be unsuccessful. Wealth-holders would reduce their money holdings

with little price inducement.

4. The Krugman liquidity trap is identical to the Hicksian liquidity trap

except that the short-term rate of interest, rather than the long-term rate,

is considered. If term structure is considered exogenously determined,

then Krugman’s and Hicks’ notions are the same.


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II. Identification

A major area of controversy is the issue of whether a liquidity trap has ever been

positively identified. Keynes is explicit in saying that he knew of no real world example

of the phenomenon but suggests that it might occur in the future. He held the view that

over time the long-term interest rate would decline and speculated that at a rate of 2%, a

liquidity trap could emerge. In his famous comment about the “euthanasia of the rentier”

(1963, 376), he was recognizing that the long-term interest rate could, sometime in the

future, fall to the vanishing point, creating a permanent liquidity trap.

As noted above, Marriner Eccles believed the United States was experiencing a

liquidity trap in the 1930’s. He used this diagnosis to justify not pursuing expansionary

open market operations during the Great Depression. Although his position was widely

accepted at the time, Lauchlin Currie (1934), and later Milton Friedman and Anna Swartz

(1963), questioned the diagnosis. The alternative view of Currie, Friedman and Schwartz

is that if the Federal Reserve had done more to expand reserves, the money supply would

have increased and the depression could have been alleviated. In other words, they deny

the existence in the 1930's of an Eccles liquidity trap in which banks would continue to

absorb new reserves without lending them out. Since Keynes and Eccles were working

with different definitions of the liquidity trap, we cannot conclude that they disagreed on

the diagnosis of the situation in the 1930’s. Like the economists from Oxford University,

Keynes recommended expansionary fiscal policy to cure the depression, so he may well

have agreed with Eccles about the impotence of monetary measures.

The question of what could have been in the 1930’s has not been resolved.

Krugman (1998) takes the view that with Japan’s experience in the mid-1990’s, the


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liquidity trap had made a return, implying that it had been around before. Other

prominent economists, however, disagree that a liquidity trap has ever occurred. Brunner

and Meltzer (1968), for example, have studied the demand for money and find no

evidence it is, or has ever been, perfectly elastic. One piece of evidence that they point to

is the period in 1936-37 during which reserve requirements were increased. The policy

caused interest rates to increase while banks reduced bank assets. If the demand for

money was perfectly elastic, one would not expect interest rates to increase. This

evidence points against the Hicks concept of the liquidity trap. It does not, however,

challenge the Eccles or the Keynes concept. Brunner and Meltzer have found a

weakness, not in the general idea of a liquidity trap, but in the elastic money demand

formulation originally presented by Hicks.

Another perspective is given by Bernanke (2002) who notes that during the

depression, policy makers inferred from the low short-term interest rates that monetary

policy was loose. In fact, because of deflation, real rates were high and monetary policy

was tight. The error that Eccles was making was in misinterpreting the stance of

monetary policy. He had concluded that loose monetary policy was ineffective from a

mistaken belief that monetary policy was indeed loose.

The question of whether a liquidity trap can be identified in Japan is equally

controversial. Unlike in the case of the U.S. in the 1930’s, it is apparent that the Bank of

Japan has been pursuing expansionary monetary policy through its purchase of short-term

government securities. The short-term rate has been driven close to zero and one could

argue that money and short-term securities have become close substitutes. The evidence

supports the conclusion that, at the least, a Krugman liquidity trap is present. The


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position of the liquidity trap skeptics is that close substitutability between money and

short-term bonds does not imply that monetary policy, more broadly defined, is

ineffective. They argue that the economy can always be stimulated if the central

monetary authority is prepared to engage in what have been termed “unconventional open

market operations. ” If the monetary authority were to purchase long-term securities or

foreign exchange, they should be able to stimulate the economy. Bernanke (2002, 5), for

example, writes:

… under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is zero. Along similar lines, Brunner and Meltzer (1988) criticize macroeconomic models

that include only money and bonds as possible assets. They insist, instead, on a model in

which bank credit, the money stock, interest rates and the price level of real assets are

jointly determined. They write that “the idea of a liquidity trap, suspending all

connection from the money market to the output market, is firmly anchored in the

structure of the IS/LM system. This idea is untenable once we include interaction with

the credit market” (Brunner & Meltzer 1988, 447). They emphasize that monetary policy

works through affecting relative prices and that there are many relative prices to consider.

The liquidity trap skeptics recognize that the banks in Japan are accumulating

excess reserves so can allow that an Eccles liquidity trap is in operation. But the reason

for the excess reserves, in their view, is not the perfect substitutability between bonds and

money but rather the weakness in the banking system. Analysts of the Japanese banking

system have noted that banks are reluctant to make loans in a shaky economic

environment because they fear becoming undercapitalized and being brought under the


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direction of the regulators. Their strategy has been one of avoiding any downside risk by

not lending. Krugman counters this line of argument by saying that if a bank is short on

capital the incentive is to take on more, not less, risk. It is true that if a bank is on verge

of being closed, it pays to take large risks. But for banks with enough of a capital

cushion that they can survive the recession, the optimizing choice could be to avoid risk.

In sum, a clear identification of a liquidity trap can be found only if one is

employing specific definitions of the term. An Eccles liquidity trap in which banks

accumulate excess reserves is apparent in Japan, as is a Krugman liquidity trap in which

money and short-term bonds are close substitutes. The implication for monetary policy

of these types of liquidity traps is the uncontroversial one that open market purchases of

short-term securities will be ineffective in stimulating the economy.

III. Analysis

The standard approach to analyzing the liquidity trap is the IS-LM model

introduced by Hicks (1937). The model provides a simple framework that ostensibly

allows an analyst to generate the results of Keynes’ theory, quickly and unambiguously.

It specifies some economic magnitudes as endogenous (determined within the model) and

others as exogenous (given from the outside and not explained within the model).

Equilibrium conditions are specified and the model generates the values of the

endogenous variables that simultaneously satisfy the equilibrium conditions.

As noted above, the model has been criticized by Brunner & Meltzer (1988) for

abstracting from the full range of asset markets and from financial intermediation. In the

IS-LM model, investors have a choice between holding money or bonds. There are no

equity markets, no banks, and there is a single type of bond. The position held by


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Brunner & Meltzer, along with other liquidity trap skeptics, is that under a fiat money

system, the central monetary authority can always increase either prices or output. Even

in a situation in which bonds and money become perfect substitutes (as in the Hicks and

Krugman liquidity traps), the central monetary authority can pursue expansionary policy

through buying other types of assets.

The IS-LM model has also been criticized, on a more general level, for distorting

many of Keynes’ original insights. Post Keynesian economists (e.g., Chick 1983,

Davidson 1972) argue that a system of simultaneous equations cannot properly

incorporate Keynes insights about radical uncertainty. Joan Robinson (1979, iv) stresses

that the “logical time” construct of an equilibrium model is inappropriate for analyzing an

economy that moves from an irrevocable past into an unknowable future. She suggests

that economic models should be in historical time. The same point was made much

earlier by Thorstein Veblen (1898) who wrote of need for economists to employ the

concept of cumulative causation, rather than equilibrium.

We saw in the previous section how the simultaneous equation approach to

analyzing the liquidity trap presents a problematic interpretation of Keynes' brief remarks

in the General Theory about an economy in a liquidity trap. In Hicks’ model, a liquidity

trap is associated with a perfectly elastic demand for money, which implies that policy

makers can neither lower nor raise the interest rate. Keynes’ comment about the liquidity

crisis in the United States in 1932 indicates that he recognizes that it is possible for policy

makers to increase the interest rate, even when they cannot cause it to fall. An historical

time model is necessary to capture Keynes liquidity trap because the response to the

policy change depends on where one begins.


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Krugman (1998) is critical of the IS-LM model because it considers only one

period and does not capture decisions directed towards the future. To remedy the lacuna,

he adopts an intertemporal representative agent model in which the agent maximizes life-

time utility. The agent can borrow or lend at a nominal interest rate, i, by selling or

buying one-period bonds. The real interest rate in such a model is equal in equilibrium to

the level of time preference, that is, the discount factor the agent applies to future

consumption when he computes his life-time utility. The monetary authority is assumed

to be committed to price stability in the sense that it has a target price level that it

attempts to maintain. Krugman’s model allows him to show that if the monetary

authority is committed to price stability, then the higher the current price level, the lower

the nominal interest rate:

The easiest way to think about this is to say that there is an equilibrium real interest rate, which the economy will deliver whatever the behavior of nominal prices. Meanwhile, since the future price level P* is assumed held fixed, any rise in the current level creates expected deflation; hence higher P means lower i. (Krugman 1998, 145)

Krugman considers what happens in his model when the real rate of interest is

negative and prices are perfectly flexible. He argues that in order to reach equilibrium,

the economy will have to experience inflation. Since the nominal interest rate will never

fall below zero, the only way in which a negative real rate, defined as the nominal rate

minus the expected rate of inflation, will emerge will be if the expected rate of inflation is

positive. He goes on to say the way in which the economy gets the inflation in the next

period is by having deflation in the current period.

In a flexible price economy, the necessity of a negative real interest rate does not cause unemployment. … In this model the problem does not arise, but for a reason that is a bit unusual: the economy deflates now in order to get inflation later. (ibid., 147)


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The liquidity trap in Krugman's flexible price model is not a problem for the

economy. On the contrary, it is part of the solution. In order to get the negative real

interest rate that the economy needs, agents are pulling down the price level through

hoarding cash. When the nominal interest rate reaches zero in the model, savers hold

onto money, rather than lending it out through selling the one-period bonds. Since they

are keeping the money out of circulation, the market clearing price of the single good

falls. But because the agents believe the central monetary authority is committed to price

stability, they think the price level will go back up by the next period--hence the

inflationary expectation that leads to a negative real rate of interest rate.

A problem only arises when prices are not flexible downward. In this case, the

hoarding of a cash in a liquidity trap leads to a fall in output and a rise in unemployment.

The conventional view of deflation is that it is a cause of unemployment. The

unemployment arises from producers' scaling back production because they fear the value

of the output to be received in the future may be lower than the value of the inputs to be

paid out today. In contrast, Krugman's view is that unemployment is caused by not

enough deflation. If prices were perfectly flexible downward, the economy would get the

inflationary expectations it needs to create a negative real rate of interest out of a zero

nominal rate.

The counter-intuitive nature of Krugman's results comes from the high level of

abstraction of his model. The model has only one good and economic agents who

optimize without being plagued by doubts or fears. The reality of a deflationary situation

is that there are multiple goods and services whose prices are all falling at different rates.

Producers are uncertain whether their output prices will fall at the same rate as their input


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prices so even if the interest rate at which they borrow is perfectly adjusted for deflation,

they have reason to curtail their production.

On the basis of his model, Krugman concludes that to remedy the unemployment

caused by not enough deflation, the central monetary authority should make a credible

commitment to inflation so that the necessary inflationary expectations will be created.

Increasing the money supply in one period will not be effective if the economic agents

think that it is a temporary measure. In order for the monetary authority to get the

economy out of the trap, they must get the agents to believe that inflation will be

sustained into the future.

Krugman assumes that what is true within the context of his model is true in the

context of the real world:

Let me say this perhaps more forcefully than I have in the past. Inflation targeting is not just a clever idea—a particular proposal that might work in fighting a liquidity trap. It is the theoretically ‘correct’ response—that is, inflation targeting is the way to achieve in a sticky-price world the same result that would obtain if prices were perfectly flexible.” (Krugman 1999, 3)

But the level of confidence that he places in his policy proposal can only be

justified if all the factors that have been abstracted from in the model are, indeed,

irrelevant in the real world.

The macroeconomics of Keynes provides a good contrast with Krugman's

analysis. Keynes did not abstract from the doubts and fears that plague economic agents,

especially in a time of financial crisis. His most radical departure from orthodox

economic theory was his theory of the rate of interest which he took to be a psychological

phenomenon determined by uncertain expectations and disconnected, in all but the most

tenuous way, from the factors of productivity and thrift. Similarly, he thought investment


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spending in the economy was driven not by the solution to a precise optimization

problem but rather by what he famously termed "animal spirits."

Krugman reverts to a pre-Keynesian theory of interest in which the interest rate is

construed as the price that equilibrates the supply of saving with the demand for funds for

investment. Keynes rejected this theory on both logical and empirical grounds. The

logical argument was that saving and investment are identically equal so their equality

cannot be represented as an equilibrium condition. The empirical argument pertained to

the actual dynamics of the bond market. As a participant in financial markets, he realized

that the force of speculation was the principal driver of securities prices, easily

overwhelming the real factors of time preference and capital productivity. He writes: "the

rate of interest and the marginal efficiency of capital are particularly concerned with the

indefinite character of actual expectations, they sum up the effect on men's market

decisions all sorts of vague doubts and fluctuating states of confidence and courage." In

Krugman's model, in contrast, the economic agents have neither indefinite expectations,

nor vague doubts.

George Soros, like Keynes, demonstrated, through his success as a market

participant, a good intuitive grasp of financial markets. And like Keynes, he recognizes

the disturbing role of speculation: "there can be no assurance that 'fundamental forces'

will correct 'speculative' excesses" (Soros 1987,30). His views on the limitations of

conventional economic theory, as well, echo those of Keynes:

People are assumed to act by choosing the best alternatives, but somehow the distinction between perceived alternatives and facts is assumed away. The result is a theoretical construction of great elegance that resembles natural science but does not resemble reality. It relates to an ideal world in which participants act on the basis of perfect knowledge and it produces a theoretical equilibrium in which the allocation of resources is at an optimum. It has little relevance to the real


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world in which people act on the basis of imperfect understanding and equilibrium is beyond reach. (ibid., 12)

Soros presents an alternative to equilibrium theorizing with his concept of

reflexivity. He argues that in an environment in which the parameters of the system are

constantly fluctuating, as they are in financial markets, the idea of an equilibriating

process becomes irrelevant. When economic decisions are driven by expectations formed

with incomplete and changing information, the achievement of an equilibrium is

unrealistic. It is only when the parameters are fairly constant, that is, under the condition

of ceteris paribus, that conventional economic models make sense. The idea of

reflexivity is that the economic agents' expectations can influence economic outcomes.

Those outcomes in turn influence expectations.

When a situation has thinking participants, the sequence of events does not lead directly from one set of facts to the next; rather it connects facts to perceptions and perceptions to facts in a shoelace pattern. (ibid., 43)

Applying a non-equilibrium approach, such as Soros's theory of reflexivity, to the

analysis of the liquidity trap leads to very different conclusions from those found by

Krugman. It does not follow, for instance, that deflation in a liquidity trap will lead the

economy to a full-employment equilibrium position. On the contrary, deflation is likely

to make things worse.

Outside of a full-employment equilibrium model, deflation is associated with

reduced spending, often arising from a sense of uncertainty from the future. Investment

spending by firms is sensitive to projections about future demand and, in Japan,

consumers are known to increase their rate of saving when economic conditions are

perceived to worsen (Wilson 2000). In a reflexive pattern, the perception that the


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economy is in poor shape leads to that reality which in turn reinforces the perception.

Once the cycle gets underway the tendency is to move further from the full-employment

equilibrium position.

The ineffectiveness of monetary policy in a liquidity trap can also be explained by

uncertain expectations. Solvent firms will be hesitant to expand production and take out

more loans even at low rates of interest because they are not confident that business will

be strong enough to pay them back. Similarly, banks will be reluctant to lend. The result

will be that new reserves injected into the banking system will accumulate as excess

reserves in the banks—an Eccles liquidity trap. The lack of borrowing and spending has

a contractionary effect and reinforces the perception of uncertainty about future

prospects.

IV. Remedies

Fiscal policy is normally the first policy option that comes to mind as a solution to

a liquidity trap. Throughout the 1990's, however, Japan's efforts at fiscal stimulus were

unsuccessful in counteracting the slump. One possibility is that the magnitude of the

government deficits was insufficient. Many observers concluded that politically it would

be impossible for Japan to run up a large enough budget deficit to turn the economy

around. This conclusion led to the search for other remedies.

One's analysis of a liquidity trap has a direct bearing on recommended remedy.

Krugman's remedy of having that the central bank set a goal of creating inflation appears

strange and highly unconventional but he insists that it is in line with straightforward

economic analysis:


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In the case of the liquidity trap … conventional textbook models imply unconventional policy conclusions—for inflation targeting is not an exotic idea but the natural implication of both IS-LM and modern intertemporal models applied to this unusual situation. (Krugman 1999, 11)

Since Krugman's policy recommendation follows logically from his economic

models, there are two possibilities to be considered: either the conventional wisdom

about the desirability of a stable price level is wrong and his policy recommendation is

correct , or the conventional wisdom about the desirability of a stable price level is

correct and the models that Krugman is employing are wrong.

The reason inflation is thought to be corrosive to the economy is that it creates a

climate of uncertainty in which business planning becomes more difficult. With an

inflation, as with a deflation, prices will change at different rates. Producers will scale

back their plans if they are unsure about the profitability of new ventures, owing to the

uncertainty about whether output prices will rise as fast as input prices. The problem

with the macroeconomic models that Krugman uses to analyze the liquidity trap is that

they abstract from the multiplicity of prices and the effect on the level of output of

uncertain expectations. Unless, Krugman can demonstrate that uncertain expectations are

irrelevant to the determination of the level of output, the conventional wisdom should

stand.

The idea proposed by Meltzer and Bernanke of stimulating the economy with

open market operations through purchasing long-term bonds and foreign exchange might

be successful, but could be thwarted by pessimistic agents. The purchase of long-term

government bonds will bring down the rate of interest government debt but may not do

much to reduce the interest rate paid by businesses. A risk premium is factored into


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business loans which will be greater, the worse the perception of the economy's

prospects. Buying foreign exchange will weaken the domestic currency and stimulate

export industries but much depends on the perception of the permanence of change in the

rate of exchange. For instance, if export firms suspect that trading partners might react

by allowing their currencies to fall, they may not bother to expand their operations.

Another remedy to the liquidity trap that has been suggested for Japan is to recapitalize

the banks so that they will be less reluctant to lend. Insofar, as the banks are not lending

because of fears of becoming undercapitalized, the remedy should work in the right

direction.

If one accepts the importance of uncertain expectation in determining the course

of the economy, the greatest policy challenge in a liquidity trap becomes one of changing

the perception of the economic agents about the future state of the economy. Just as

reflexivity can lead to a downward spiral, it can also create an upward trend when

perceptions change. The problem is that while the monetary authority can exert control

over price signals, it has no way of controlling the way in which the signals are

interpreted.


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References Bernanke, B. 2002. Deflation: making sure “it” doesn’t happen here. Remarks before the National Economists Club, November 21, 2002. <http://www.federalreserve.gov/boarddocs/speeches/2002> Brunner, K. and A. Meltzer. 1968. Liquidity traps for money, bank credit, and interest rates. Journal of Politicial Economy 76:1-37. --------------------------------. 1988. Money and credit in the monetary transmission process. American Economic Review 78:446-451. Chick, V. 1983. Macroeconomics after Keynes. Deddington, U.K.: Philip Allan.

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Notes on the Liquidity Trap