One more point on the liquidity trap

Casey Mulligan's post, on the liquidity trap argument, is spot on.  Here's another simple thought experiment.  Let's say that, for reasons of technology, currency disappeared.  All transactions would be made with POS or cell phones, backed by interest-bearing assets, in one form or another.  You might think that's unlikely today but it's at least possible in the future.  In any case, it's a thought experiment.

In this world there would no longer be a trade-off between currency and interest-bearing assets, as we find in traditional Keynesian models.  There would be no substitution out of one and into the other and there would be no swapping of currency for interest-bearing assets.

What would the macroeconomics of this world be like?  Would the AD curve slope upwards?  Would increases in employment be contractionary?  No and no.  It would only be slightly different from our current world, a point Kroszner and I made in our book Explorations in the New Monetary Economics.  It just doesn't matter that much if you pay for your retail transactions by leaving a five on the counter or by using a credit or debit card backed by interest-bearing assets.

Liquidity trap arguments are themselves a kind of trap.  The theorist finds one situation where the traditional marginal equality between various rates of return is disrupted and people stand at a corner for one of their portfolio positions, namely cash vs. interest-bearing assets.  The model then has consistency requirements, in the form of interrelated mathematical equations, which "spread" the counterintuitive results across the entire economy.  But that's assuming the model is a more powerful description of reality than it actually is.  It's better to side with common sense instead.

Addendum: Arnold Kling offers related comments.


REgarding Mulligan's argument, college graduates are a predictable seasonal supply. Thus couldn't a liquidity trap proponent argue that they won't depress wages because their arrival was already well planned for? Similar to people not running out of turkeys around November. We know the big demand is coming.

The min wage argument I think stands best.

Let's say that, for reasons of technology, currency disappeared.

Not a thought experiment! It actually almost disappeared in England in the late 17th century. I highly recommend Newton and the Counterfeiter for the history of how the same guy who invented calculus, classical mechanics, and optics also helped spring England from its liquidity trap.

The lesson of that history is that there is not a difference in kind between government-backed currency and other interest-bearing notes -- which I take to be Tyler's main point.

I think we are ready to take a step beyond that approximation, however, by observing how the structure of the financial institution can have dramatic consequences on the valuations of interest-bearing accounts at otherwise independent institution. In particular, as the density of links among these institutions increases through derivatives and leverage, the likelihood of correlated moves to buy and sell increases. The legal and political boundaries between institutions have been treated as impermeable; in fact, it the way the cash flows in crisis that truly defines what boundaries are permeable and what not -- and hence, for lenders, where their money is safe.

Models are not good or bad; they're either useful or not useful.

Re; "as we find in traditional Keynesian models". Don't you mean "as we find in traditional monetarist models"?

Keynesianism is an intellectual trap. If you follow the precepts of Keynes you find yourself in a situation that he describes happening. Then you are stuck.

@ Michael Martin:

"The lesson of that history is that there is not a difference in kind between government-backed currency and other interest-bearing notes -- which I take to be Tyler's main point."

I have to confess, I'm not entirely sure that Tyler actually has a point here. The modern concept of a liquidity trap has nothing to do with currency whatsoever, and Tyler's thought experiment merely serves to obfuscate that fact. (To see how this is true, ask yourself: what are the units we use to measure the value of these various asset-backed accounts, and how do those units relate to price?)

As presently conceptualized, a liquidity trap, by definition, occurs when short-run interest rates are at or near zero. That definition is justified by noting that the underlying problem in the circumstances that we describe as a "liquidity trap" has to do with a stark reduction in the "V" of the "P = MV" equality, not the "M" (which is what Tyler's thought experiment addresses).

What I find astounding is that someone who has written a book on monetary economics would make such an elementary error in reasoning. It's difficult for me to not see this as deliberate as opposed to being merely misguided.

Well, let's further assume that this economy is one where no social security system exists as is the case in China, so everyone earning a wage is putting on average 20-30% of their income into interest bearing accounts, in a world economy where the US is neither increasing buying of goods nor borrowing, so this means:
1. investment in new factories will only offer reduced rates of return as the excess capacity drives down returns on existing factories
2. buying US debt will only drive down interest rates without increasing total debt.

While one might argue that getting no return on invest will drive up consumption, but if the stagnant economy persists into the future, then one would logically fear having insufficient savings for retirement or illness, so savings will not decrease, but might increase.

If the deposits are in large excess of demand for borrowing, then in this work where there is no cash, deposits might have negative interest as banks charge to hold deposits to be profitable.

The assumption that one can always find investments that have positive returns seems to me to be a stretch. Clearly the problem two to three years ago was finding productive investments, so the increasing amounts of money fed a asset pump and dump ponzi frenzy where everyone was convinced asset prices would keep rising forever and create wealth from nothing.

Rick Schaut,

It was I, not Tyler who confused a currency crisis with a liquidity trap when I called the 17th century crisis in England a liquidity trap. Of course it's not. But they are two side of the same coin. In a currency crisis, the scarcity of the medium of exchange prevents parties from transacting; in a liquidity trap, the plentitude of the medium of exchange prevents parties from transacting.

The problem is the same. A currency is only good as a widely agreed-upon unit of value. I don't care what you call the problem, but it's no conceptual error to see them related.

You should read and re-read Brad deLong's comment. Your post labels as a liquidity trap a set of circumstances ( no "trade-off between currency and interest-bearing assets"; "...people stand at a corner for one of their portfolio positions..") that describe the naive quantity theory of money.

Dr. Cowen,

In your opinion, are "liquidity traps", the result of a maturity transformation crisis or not?


The trade off Cowen has in mind is that in Keynesian models, when the interest rate on interest bearing assets gets lower, there is an increase in the demand for currency.

Without currency, when the interest rate on nonmonetary assets decreases, so does (or can) the interest rates on monetary assets.

There is no zero nominal bound. The zero nominal bound is an artifact of currency having a zero nominal yield and all the other monetary assets being redeemable in currency. No currency, and this is no longer an issue.

There is no liquidity trap.


Maturity transformations can only impact aggregate nominal expenditures if zero nominal yield, fixed price currency sits there at the bottom.

Of course, people might choose to work less or consume more. If people work to save to accumulate assets that pay a good return, then worries about the risk associated with that return might cause people to work less because they don't want to save as much. This is an optimal response.

The problem occurs when people continue to try to work and save by accumulating currency. The nominal yield on currency is fixed. And so the price level and its rate of change must adjust to clear markets. If prices are sticky, then we have demand constrained production.

But the source of the problem is the currency. With a gold standard, then it could be gold.

With a system with no currency, the short and safe assets have negative yields if necessary and their markets can clear with the price level and its rate of change remaining on their current trajectory.

A 3% growth path for nominal expenditure would be great.

It's a little unclear how "currency" disappears. Suppose accounts are "backed" by T-bills. By definition, T-bills are merely a promise to deliver currency on a given day. So would the terms of T-bills change? Would they merely yield more T-bills? All that would seem to accomplish is to change T-bills into currency, with a particular rate of inflation built in. Since all currency in the economy then yields a given rate of interest, the government would have to offer better rates of interest on other securities (if it is to raise money at all), let's call them meta-T-bills. Is anything accomplished other than a change in terminology?

Maybe you're imagining a different scenario. But whatever it is, the shift away from "currency" is endogenous and demands a better explanation than 'Suppose there were no cash...'

Ryan Vann,

Prices must be defined in terms of something, and that something will always be a currency of sorts, whether or not it pays interest (in itself, or something else). If we assume away currency, prices can't be defined in 'dollars', because dollars don't exist anymore. Perhaps they'll be defined in terms of 'T-bill units', or something like that, but there will be some standard (ie, a unit of currency).

In basic theory, we can of course imagine a list of prices for any one good (basically a textbook exchange economy with its price vector). But it's a little silly to imagine such a thing actually happening. Some currency would emerge, government-sanctioned or not.

It sounds like this post is supposing that currency is still available, but that people choose not to use it. ("...for reasons of technology...", not for reasons of policy.) That movement away from currency to...something else, I'm still not sure what, is certainly an endogenous process.


Oops.. It is _now_ possible to make purchases of an equal nominal amount. You quote a price for $10. You end up with an increased balance of $10. You can now write checks for $10. If you hold that money in your account, interest can be credited. But, if the interest rate is negative, the balance decreases over time.

All transactions would be made with POS or cell phones, backed by interest-bearing assets, in one form or another.

Why would any sane person accept payment backed by an interest-bearing asset where the interest rate was negative?


The cash/dollars wouldn't technically exist if I am reading the concept correctly, only the assets would exist, priced in dollars. Kind of hard to wrap the noggin around, but it makes sense when you think about it further.

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