Re: liquidity trap?
Source Jim Devine
Date 02/09/20/13:53

> [I saw a piece two days ago wherein Allan Meltzer argued that
> there has never been a real world example of an economy in a liquidity trap.
> Any comments on the concept and it's applications/referential validity?]

1. The original conception of the LT was that of Keynes. I understand it as
more of a disequilibrium concept than do the neoclassicals. The idea is that
people fear the bond market, the next-best alternative to holding money
(liquidity): they fear that interest rates have no place to go but up, so
that bond prices have no place to go but down. The latter means that any
financial investment in the bond market will cause capital losses, so people
eschew this route and hold onto money instead, if they can.     
People think that interest rates can't fall any further when they're already
low, so that the LT means that neither normal market forces not monetary
policy can lower interest rates any further. Every increase in liquidity
engineered by the central bank is snapped up by anxious folks trying to
escape the bond market, preventing a fall in rates. (I see this not as the
textbook case where the money demand curve is flat, but instead as where the
normally-sloped demand for money curve shifts out in response to increases
in supply.)

The NC types see this as a flat LM curve, as part of the infamous IS-LM
model, which is hard to find empirically. (Of course, Meltzer is a hard-core
monetarist and doesn't want to find a LT. NC economists also find it hard to
find disequilibrium cases.)  I see this instead as part of the reason why an
excess of (broadly defined) saving over (broadly defined) real investment
doesn't lead to an automatic equilibrium at the given level of income and
output and instead leads to a fall in income.

2. The popular LT that Krugman sees came after Keynes: it's the idea that
the nominal interest rate _can't_ fall below zero. (This is approximate:
holding money pays the benefits of liquidity, so interest rates can't fall
below that. Also, I heard on pen-l that in peculiar circumstances in Japan,
nominal rates actually went below zero.)

3. Also, there's a common confusion between _any_ weakness of monetary
policy and a "LT." However, monetary policy can be weak because of "a
vertical IS curve" situation, where businesses and individuals don't want to
borrow (no matter what the interest rate) because they currently face a
combination of excessive debt, unused capacity, over-building of housing,
and pessimistic expectations. Further, it's possible that bankers don't want
to lend no matter the interest rate because they're fearing "runs" on the
bank and/or they're saddled with bad loans. (The latter is akin to a LT,
since banks are struggling to have excess reserves and/or more reasonable
ratios of equity to assets.)

I think this last case is a better story of what's happened with monetary
policy in Japan, perhaps combined with #2. But I am far from being an expert
on Japan...

Jim Devine

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