The Liquidity Trap Revisited

In a rather eloquent paper, Paul Krugman illustrated the idea of a Liquidity Trap, which he suggested existed in Japan in the 1990s. It is a situation where high-powered money (also known as monetary base) and the bonds act as perfect substitutes due to marginal interest rates offered by the bonds.

Fundamentally, liquidity trap is a credibility problem in which central bankers have difficulty convincing the public of their commitment to maintaining near zero interest rates. The ineffectuality of the monetary policy lies in the markets’ belief or lack of thereof, that given the opportunity, the central bank will revert to its original stance of price stability i.e. any current monetary expansion is merely transitory. The traditional view of the monetary policy being ineffective and fiscal expansion being the only panacea is incomplete. Irrespective of the structural problems facing the economy, the monetary expansion will in fact be effective if it is perceived to be permanent and will raise prices (in a full-employment model) or output (if current prices are predetermined). Essentially, the central bank can bootstrap the economy out of the trap. Krugman however, principally dismissed any fiscal involvement on grounds of a Ricardian equivalence argument. However, if any fiscal intervention was to be allowed, it must be carried out concurrently with zero interest rates and slowly phased out as inflation expectations grow.

Since December 2008 the Federal Reserve has adopted the stance of near zero interest rates of and the occasional monetary stimulus. Unemployment figures haven’t dipped as expected; still hovering at around 8%.

Plato states in the Republic,” The only solution to political and personal troubles is for true philosophers to become kings, or for current rulers to become true philosophers”. However, given the political stalemate in the run-up to the presidential elections with a lack of consensus over substantial fiscal policy measures to deal with the labour market stagnancy, the Federal Reserve decided to circumvent this route and announced QE3. This time though, it has signalled a more permanent and sustained expansion via an open-ended round of easing via asset purchases with an additional guidance to leave interest rates near zero till late 2014 to mid-2015.

If, however real interest rates turn negative, consumers might invest abroad. With the lucrative world of Islamic instruments and Renminbi bonds on offers, the options for investors are aplenty. This, in turn, would rob domestic banks of deposits and potentially limit bank lending. Higher inflation could also lead to higher long-term interest rates for corporate borrowers, again dampening the demand stimulus. Finally there are potential repercussions from currency depreciation, that while offers a reduction to the national deficit, it harms the greenback’s stance of a stable reserve currency and the T-bonds’ risk free status.

Carrying strong hues of a country in a liquidity trap where previous transitory efforts to prime pump (or jump-start) the economy haven’t delivered, it is indeed a strong signal that the Fed has sent out. It is in a crunch. Whether the market has factored that in or even in fact comprehended remains rhetorical.


Harding, R et al, 2012. Bernanke takes plunge with QE3. Financial Times, 14 Sep. p. 1.

Krugman, P.R., 1998. It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap. Massachusetts Institute of Technology.

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