The subtleties of the liquidity traps

One of the older definitions of the liquidity trap is that excess cash balances get absorbed into hoards.  That clearly isn’t going on today because sales are booming.   The unwillingness of people with liquid assets to invest is another common aspect of the traditional definition; that’s not the case today either, even though we might wish investment were stronger.

Is there a “trap” at one portfolio margin or at all margins fanning out from cash balances?  It makes a big, big difference.  Today there is a trap at the money-bonds margin (and even then not all bonds), but not at most other margins.  Not the money-goods margin, for instance.

Whether we are in a liquidity trap is not always an either/or proposition.  An economy could face some zero bound constraints on particular kinds of monetary policy without a full liquidity trap model applying across the board.

It makes a big difference how many margins are covered by “traps.”  When there is a bottomless demand for money hoards, and all margins encounter traps, the correct model does seem to invert the slope of its AD and AS curves, as Krugman sometimes suggests.  Empirically, that is not the case today and probably never has been the case.

When there is a trap only at the money-bonds margin, it is a mistake — both empirically and theoretically — to invert the slopes of the AD and AS curves.

Like most econbloggers, I tend to favor simple models.  Yet a more complex model — with more disaggregation, with explicit distinctions between local and global properties, and with explicit stability conditions, may be needed to show this mistake.  (This is one example of where “high theory” really does come in handy.  In its place, offering casual remarks about the weakness of the real balance effect is asking the wrong question and does not fill the gap.)  In the meantime common sense and empirics suffice to reject it.

When there is a trap only at the money-bonds margin, positive aggregate supply shocks tend to be expansionary.  They generate money income, jobs,  and boost real rates of return.  It is a slow and painful way to recover from a recession, but indeed it is a way to recover and it’s what we have been doing.

Any claim about the duration of a liquidity trap has an implicit dual in real business cycle theory, about the enduring weakness of real rates of return.  For all the brickbats thrown at rbc, the liquidity trap proponents are relying on it, while keeping real rates of return in the background of their arguments.  A booming economy on the real side gets out of a one-margin liquidity trap much more quickly than does a stagnating economy.

If one wishes to do exegesis of Krugman’s liquidity trap posts, he often makes the common sense and indeed indisputable observation about a liquidity trap at one margin, money-bonds.  Very often he then draws sensible conclusions from this starting point, such as the need to analyze the credibility of monetary policy.  Other times (pdf) he slips into writing as if all margins were covered by traps and the AD and AS curves invert their slopes.  As I’ve mentioned, that is simply a mistake and the extreme properties of those models do not follow from a world where the trap is at a small number of margins only.

Arnold Kling makes some related observations and also serves up the requisite links.


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