Liquidity Trap - Conceptual Evolution

Conceptual Evolution

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 policy initiatives tried to stimulate the economy through methods other than the reduction of short-term interest rates.

When the Japanese economy fell into a period of prolonged stagnation despite near-zero interest rates, the concept of a liquidity trap returned to prominence. However, while Keynes's formulation of a liquidity trap 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, firstly, the assertion that monetary policy affects the economy only via interest rates, and secondly, the conclusion that monetary policy cannot stimulate an economy in a liquidity trap. Declines in monetary velocity offset injections of short-term liquidity.

Much the same furor emerged in the United States and Europe in 2008–2010, as short-term policy rates for the various central banks moved close to zero. Paul Krugman argued repeatedly in 2008-11 that much of the developed world, including the United States, Europe, and Japan, was in a liquidity trap. He noted that tripling of the U.S. monetary base between 2008 and 2011 failed to produce any significant effect on U.S. domestic price indices or dollar-denominated commodity prices.