Monetary and fiscal policies in a liquidity trap

2 April, 2015 at 13:19 | Posted in Economics | 5 Comments

Low inflation makes cash more attractive to investors as a store of value, everything else equal.

This makes the liquidity trap easier to occur and gives the Fed less room to reduce the real interest rate as desired during a recession. Furthermore, quantitative easing through LSAPs [large-scale asset purchase] can reinforce the liquidity trap by further reducing the long-term interest rate. In other words, more monetary injections during a liquidity trap can only reinforce the liquidity trap by keeping the inflation rate low (or the real return to money high).

It's The Liquidity Trap Stupid BS 2

Therefore, the correct monetary policy during a liquidity trap is not to further increase money supply or reduce the interest rate but to raise inflation expectations by raising the nominal interest rate. If LSAP policies are reversed and the money supply decreases as the Fed sells assets in the marketplace, the nominal interest rate will increase and investors will be more likely to shift their portfolios away from cash toward interest-bearing assets. If demand for money decreases more than proportional to the decrease in money supply due to upward pressure on the interest rate, inflation will increase. In other words, only when financial assets become more attractive than cash can the aggregate price level increase …

The irony is that expansionary monetary policy is often called for only when the economy is in a recession. This policy dilemma makes economics a dismal science. One way to escape from it is to use expansionary fiscal policy (as suggested by the economist John Maynard Keynes). However, with the already high level of government debt across industrial countries, it takes courage and vision to implement bold expansionary fiscal policies.

Maria Arias & Yi Wen

The only way to escape the policy dilemma is to use expansionary fiscal policy. And, indeed, that takes courage and vision — unfortunately not exactly übersupplied with today’s central banks …




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  1. “If demand for money decreases more than proportional to the decrease in money supply due to upward pressure on the interest rate, inflation will increase.”
    It will, will it. Just like that.

  2. This was pretty stupid. Expansionary monetary policy by tightening money. It’s Cochrane all over again.

    • Krugman, back in 2013, agrees on the importance of inflation expectations, but rather than hiking the nominal interest argued for central banks keeping “the pedal to the metal even as the economy begins to recover.”

      [“Here’s the thing, however: the economy won’t always be in a liquidity trap, or at least it might not always be there. And while investors shouldn’t care about what the central bank does now, they should care about what it will do in the future. If investors believe that the central bank will keep the pedal to the metal even as the economy begins to recover, this will imply higher inflation than if it hikes rates at the first hint of good news – and higher expected inflation means a lower real interest rate, and therefore a stronger economy.”]

  3. Arias and Wen are talking thru their rear ends. Their last paragraph assumes that fiscal stimulus increases the debt (an assumption made by many so called “professional” economists). Evidently Arias and Wen have never heard of QE. If fiscal stimulus is immediately followed by QE, the net effect is to fund fiscal stimulus with new money rather than more government debt.

    Put another way, as MMTers keep pointing out, you can’t beat simply creating fresh state money and spending it in a recession (and/or cutting taxes).

    Keynes pointed out that stimulus can be funded with new money. But perhaps Arias and Wen haven’t heard of Keynes. You really have to wonder what proportion of economists can tie their own shoe laces.

  4. What else is new? Of course only fiscal policy does the trick at the ZLB. Doesn’t matter what model you use, Woodfordian DSGE or Hicksian IS-LM. But you gotta use a model, my ergodic, unscientifc friend, to be able to make such a claim.

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