Liquidity Trap

Topics: Inflation, Monetary policy, Keynesian economics Pages: 2 (665 words) Published: May 26, 2013
In its original conception, a liquidity trap refers to the phenomenon when increased money supply fails to lower(*) interest rates. Usually central banks try to lower interest rates by buying bonds with newly created cash. In a liquidity trap, bonds pay little to no interest, which makes them nearly equivalent to cash. 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 "investment saving" curve in an IS/LM analysis, and monetary policy would thus be able to stimulate the economy even during 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...
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