ECONOMIES AROUND THE WORLD ARE IN A LIQUIDITY TRAP

'Economies around the world are in a liquidity trap. Conventional monetary policy will not be sufficient to generate recovery'. The alternative policy responses and their costs and benefits with reference to the US or the UK.'

'Economies around the world are in a liquidity trap. Conventional monetary policy will not be sufficient to generate recovery'. The alternative policy responses and their costs and benefits with reference to the US or the UK.'

It has often been argued that once interest rates fall to near zero levels, the usefulness of monetary policy is greatly reduced. In order to examine the desirability of using monetary policy to boost aggregate demand in that sort of environment, we need to consider two possibilities. First we will examine an environment where monetary policy is relatively weak, but still has some impact on aggregate demand. Then we will consider a complete liquidity trap, where even large injections of money have absolutely no impact on aggregate demand.

Assume that we are operating under an unconstrained fiat money regime, where the monetary authority is not required to maintain the currency unit at a fixed value in terms of gold or foreign exchange. In that case, as long as monetary policy has some impact on aggregate demand, then with a large enough increase in the monetary base it is always possible to generate any desired increase in aggregate demand. If monetary policy is not completely impotent, then the standard view is that, ceteris paribus, the higher the interest elasticity of money demand, the flatter the LM curve, and thus the larger the required increase in the money supply necessary to meet a given desired increase in aggregate demand. I do not intend to challenge this view. Note, however, that saying monetary policy has a smaller impact on aggregate demand is not the same as saying that monetary policy is less desirable .

If we make the assumption that the cost of printing fiat money is trivial, then there would seem to be no important extra social costs associated with the increased money creation required to offset a highly elastic demand for money. There is, however, an important benefit from open market purchases, a reduction in the net indebtedness of the government.

There are several mechanisms by which reductions in the national debt could improve social welfare. According to the standard neoclassical model, reductions in the national debt should lower real interest rates and thus increase capital investment. Of course if the demand for money is highly interest elastic, then expansionary open market operations (which reduce the stock of government debt held by the public) may have little impact on interest rates, and thus investment. Thus many economists view deficit spending as being both more effective and more desirable than monetary expansion in an economy with near-zero interest rates.

The preceding interpretation, however, ignores the fact that reductions in the national debt can be beneficial even if they have no impact on interest ...