Monetary Policy: Losing One's Faith Because of Liquidity Trap

Jul.16.10 | About: iShares Core (AGG)

Just a few days after getting all religious about monetary policy, Paul Krugman now seems to be losing his faith as he wallows in liquidity-trap-driven doubt:

[w]hen you have bought so much debt and created so much money that rates are near zero, the public is saturated with liquidity; from that point on, they’re holding money simply as a store of value, which makes it no different from bonds — and hence a perfect substitute for bonds. And at that point further open-market operations do nothing — they just swap one zero-interest asset for another, with no effect on anything.

So why not forget about open-market operations, and just drop the stuff from helicopters? Well, remember that at this point cash and short-term bonds are equivalent. So a helicopter drop is just like a temporary lump-sum tax cut. And we would expect people to save much or most of such a tax cut — all of it, if you believe in full Ricardian equivalence.

Wow, someone is really in a liquidity-trap funk. Luckily for Krugman and other depressed doubters, the righteous reverend of monetary policy efficacy, Tyler Cowen, is here to restore the faith:

First, cash and short-term bonds may be near-substitutes but they are not literally, strictly equivalent. The nominal rate on T-bills is not exactly zero and furthermore you can't use a T-bill for every retail purchase. The demand curve for real cash need slope down only slightly for a quantity theory result to hold. After everyone spends the new cash balances, and prices rise, people end up with the quantity of real balances which they initially desired. These equilibria have "knife-edge" properties, where "identical to T-Bills" and "nearly identical to T-Bills" do not bring the same results. Tsiang showed this in a very good JMCB article on Friedman's optimum quantity of money, in the early 1970s and you might regard it as implicit in Bewley's Econometrica article on Friedman.

Second, after a helicopter drop no one need expect future taxes to be raised to retire the money (although maybe a sufficiently credible government could create such an expectation). So there is no Ricardian motive to save the new cash, as Brad DeLong points out. Indeed, if you think there is some chance that others will spend the money, raising the price level, you will want to spend your new cash soon, so as to preserve its value against forthcoming price inflation. The resulting game-theoretic equilibrium, applying dominant strategies, again leads to higher prices, higher aggregate demand, and the desired quantity of real cash balances held.

In short, the liquidity trap is a much overrated idea so don't get all worked up over it. Monetary policy can still be highly effective in the current economic environment.

Disclosure: No positions