On The Definition Of A 'Liquidity Trap'

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Includes: RINF
by: Brad DeLong

I am going to split hairs with Robert Waldmann here…

Robert writes:

The USA is not in a liquidity trap anymore: "The output gap can be [estimated] by attempting to measure slack directly…

…The ratio of employment to prime age (25-54) population… is very low… The ratio of vacant jobs to employment is very high, the quit rate is normal and real wages have begun to grow. The pattern is very confusing… it is possible for the same person to reach very different conclusions on different days…

[But] we [do not] need to estimate the output gap to predict the Fed's response to fiscal stimulus… The Fed Open Market Committee (FOMC) has… made it very clear that they are considering further rate increases. It could not be more clear that markedly reduced unemployment will convince them to raise interest rates. The US economy is not at the zero lower bound anymore. This just means that the FOMC no longer wishes it could achieve a negative federal funds rate… This is a statement about what the FOMC will do not what it should do…

Let me disagree with Robert.

Whether or not the short-term safe nominal interest rate that the central bank controls is zero or not, an economy is in a liquidity trap when:

  • even a zero interest rate is not sufficient to raise planned expenditure to the level of full-employment output.

The central bank could be pegging the Fed Funds rate at 5%, and the economy would still be in a liquidity trap if even a 0% rate was insufficient to restore full employment.

Now there is disagreement about whether the U.S. economy is in a liquidity trap right now. The Federal Reserve doesn't think so: the Federal Reserve thinks the current short-term safe nominal Wicksellian neutral interest rate is 0.25%. But I think that the Federal Reserve is wrong. And if the Federal Reserve is wrong - if the short-term safe nominal Wicksellian neutral interest rate is still less than zero - the economy is still in a liquidity trap, even though the Federal Reserve does not think that it is.

This begs the question of whether the expansionary fiscal policy is a good thing or not. If indeed the economy still is in a liquidity trap, the Federal Reserve will learn - in which case the expansionary fiscal policy now will be beneficial, as it will save them from the consequences of their current mistakes as they learn and adjust. If the economy is not in a liquidity trap, expansionary fiscal policy will still raise the neutral interest rate - and so provide the Federal Reserve with more sea-room and a much better chance of avoiding another zero lower-bound catastrophe when the next adverse macroeconomic shock hits.

To say: "Because the Fed has raised the Fed Funds rate above zero, we are no longer in a liquidity trap, and expansionary fiscal policy no longer has a point" is, I think, to fundamentally mis-analyze the situation…