Can one be a liquidity trap denialist?

by on November 17, 2008 at 6:25 am in Economics | Permalink

Paul Krugman thinks not:

No matter how much Japan increases the monetary base now, expectations of future money supplies won’t move if people believe that the Bank of Japan will move to stabilize the price level as soon as the economy recovers. And once you realize that central banks may not be able to move expectations about future money supplies, it becomes a real possibility that the economy will be in a liquidity trap: if interest rates are near zero, money printed now just gets hoarded, and monetary policy has no traction on the real economy.

There is more so read the whole post. I'll put my comments under the fold...

Let’s say the central bank targets the (eventual) rate of price
inflation and not the price level itself.  Then even a one-shot burst
of helicopter-drop money induces more consumer spending rather than more money demand.  It was Meyer
Burstein who best explained Patinkin’s "real balance
effect" in terms of weakly dominant game-theoretic strategies.  If you
wait to spend
your money, later prices will be higher, if only with some probability
(thus it matters that the central bank commits to a preferred rate of
forward-looking inflation, rather than restoring the previous price
level; the latter would mean deflationary expectations and
possibly take away the real balance effect).  Nothing in the
Patinkin/Burstein logic requires any particular degree of optimism
about economic conditions.  In fact very pessimistic consumers may be
the most likely to scramble after goods now, again putting the real
balance effect into play and pushing up prices.  Nor is a strongly positive nominal interest rate required for the real balance effect.  Don’t be fooled by
representative agent models which draw a single flat horizontal line
for the return to holding money curve; this is about game theory.

The greater a hoard of cash you are holding, the more likely that
the spending behavior of other consumers will inflict a negative
pecuniary externality on each consumer and thus again the more likely a
real balance effect, following a helicopter drop of money.  Of course with
interdependent strategies there are usually multiple equilibria.  You
can get a "liquidity trap equilibrium" by postulating an adjustment
cost to portfolio decisions, combined with just the right kind of a
trigger strategy equilibrium (everyone holds her new money cautiously, but poised to strike with quick new spending, if need be).  In that sense I am not a pure liquidity trap
denialist although I think such an equilibrium is unlikely.

Here are my previous posts on the liquidity trap.

1 David Heigham November 17, 2008 at 7:43 am

A central bank that targets the price level is daft. It cannot achieve what it is targetting, and the market will realise that. A central bank that is targetting the expected rate of inflation is really in business.

If the target is believed, and it should be because the central bank has instruments to achieve its aims, whatever quantity of money the helicopers drop will be expected to be mopped up before the cash raises the long run expected inflation rate. Therefore it makes sense for the finders of the money to use it for cutting debt/boosting assets.

As Tyler says, it is all about game theory; but a central bank that is targetting expectations is a dominant player.

2 Nathan Smith November 17, 2008 at 8:57 am

By the way, are we using the wrong price index?

In the 1990s and up until 2005 or so, asset prices were inflating, while consumer prices were steady. The Fed ignored asset price inflation, except inasmuch as it influenced consumer price inflation.

Now asset prices are deflating. Even though this is causing major problems for the economy, the Fed is not trying to reverse it by “printing money.” Because its mandate is consumer prices?

But why should *consumer* price inflation be the kind we worry about? Now that we’ve seen how problematic asset price inflation can be (that is, of HOUSES especially, and to a lesser extent stocks), might it be reasonable to adjust the Fed’s mission to stabilize some broader price index which includes house prices and maybe even stock prices?

If the Fed had been pursuing this policy since the mid-1990s, we would have tolerated a good deal of consumer price *deflation* since then. I suspect that wouldn’t have done as much harm as the popping of the housing bubble is causing us now.

3 RobbL November 17, 2008 at 10:34 am

It would seem easy to stall or reduce the decline in house prices (at least in nominal terms) by using treasury bond borrowing to finance low interest mortgages. I think that the housing market would at least begin to stabilize if 5% or 4% mortgages were available..and it would help those in danger of losing their houses. Of course it would be a massive transfer of wealth the house borrowing community, but they are as deserving as bank stockholders.

One problem would be to stop yet another bubble.

4 jeff November 17, 2008 at 12:46 pm

The right way to target the price level would be to target the expected price level several years out. Five years out has always seemed like a pretty good interval to me. To do this, you would:

1. Decide on a target path for the price level for, say, the next ten years.

2. Use TIPS data to derive the market’s expectation of the CPI five years from now. If it’s higher than the target path, raise the federal funds rate by 50 basis points a month until the expected CPI five years out is back on path.

You could, of course, modify the rule to target a corridor rather than a path, and move the funds rate less aggressively as you approached the target, but the idea is still the same.

There is a lot to be said for targetting the price level, rather than the inflation rate. With an inflation target, the variance of your prediction error for the price level N years out grows linearly with N, while with a price level target, the prediction error variance is bounded. Less uncertainty would lead to more long term investments and eventual higher productivity.

5 Anonymous November 17, 2008 at 4:06 pm

The way that open market operations are carried is by buying government bonds with dollars. When the i-rate is 0% bonds and money are the same thing so changing one for the other makes no difference on the economy. Now if you want to have an effect you need to increase use helicopter drops. Start giving money away like crazy, so much money that it cannot be stored under mattresses, so much money that a typical family has enough cash sitting around to go out and buy a car, a house, a 62” flat screen tv, a 3 week family vacation at Disney, what the hell, so that they can buy all stocks and bonds in the US… Now tell me that that is an equilibrium, tell me that prices will not start to increase and tell me that there will not be too much money chasing to few goods. Liquidity trap my @$$!

6 notsure November 17, 2008 at 9:20 pm

The liquidity trap may show the point that we don’t yet understand how much monetary policy really does nor why. Maybe monetary policy has small and variable effects most of the time on the real economy, but since there is so much noise that monetary looks somewhat effective. In the extreme periods like now, we ask way too much of monetary policy, and so it appears ineffective. Hence, the liquidity trap. But we are always at it, anyway.

I am not sure myself of the right answer.

Or maybe monetary policy can’t ever help, but getting it wrong can really hurt.

7 J Thomas November 18, 2008 at 7:59 am

Massimo Giannini, that is exactly the metaphor we need. Thank you.

8 J Thomas November 20, 2008 at 6:42 am

Brian Macker, you have answered the question.

Yes, one can be a liquidity trap denialist. Proof by example.

9 joshua trentson March 4, 2011 at 5:24 pm

I have seen many documentary movies on liquidity trap, virtual money and large scale transactions that barely get to the citizen`s ears from time to time. It`s not that I don`t want to be up to date with this kind of news, but I sincerely prefer my life simple and serene as it is. With my mortgage, with my Easy Saver program, with my peaceful and quiet existence.

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