"I'm not sure, but in The General Theory Keynes doesn't refer to the liquidity trap in the sense of reaching a lower bound on interest rates. At least, I haven't come across it (maybe he does). I thought that this particular concept was developed in the 1950s, or at least after The General Theory?"As I suggested, the liquidity trap plays a very minor role in the General Theory, although it is there. In his chapter on liquidity preference, Keynes writes:
"There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this even the monetary authority would have lost all effective control over the rate of interest. But whilst this limiting case might become practically important in the future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest."My feeling is that J.R. Hicks's version of the liquidity trap as a horizontal portion of the money demand (and LM) curve at some positive interest rate is the most faithful representation of what Keynes was trying to say. At the same time, you can see where modern "zero lower bound" versions of the liquidity trap, like Krugman's, come from. In the 1990s, Krugman promoted the "zero lower bound" version of the liquidity trap because at that point everyone had forgotten about the concept (most of the time between Keynes and Krugman was dominated by higher interest rates). Krugman was reviving it to explain what was going on in Japan. Anyway, if you sanitize Keynesianism of all the concern with uncertainty about the future and liquidity preference, then the zero lower bound version makes perfect sense, because that's the point where cash and bonds become perfect substitutes. The only reason why the liquidity trap would take hold prior to a zero interest rate is if you have some sort of "uncertainty premium" or "liquidity premium" that you build in, which is essentially what Keynes did. I would argue that Keynesiansim never should have been so thoroughly cleansed of liquidity preference.
I also think it's important to think of the liquidity trap as more of a spectrum, or a gradually closing trap. Even if demand for money isn't perfectly elastic, if it becomes relatively elastic it makes monetary policy relatively less efficacious (note - in yesterday's post I said that money demand was "inelastic", when of course I meant "elastic" - that is now updated). Why not use fiscal policy to shift the IS curve until it reaches a point where monetary policy is more useful? When Scott Sumner scoffs at the prospect of a liquidity trap, responding "well why don't you print more money", my reaction is "why would you want to create monetary inflation - which gets harder and harder to do as you go along - when a much more effective and less distortionary option is available". I'm not terrified of inflation, but the Sumner position seems nonsensical to me, at least at a time like this. The general principle is that monetary policy becomes less useful at lower interest rates, not because of a zero lower bound (although that's a practical obstacle to a certain extent), but because of liquidity preference. Fiscal policy becomes less useful at higher interest rates where monetary policy can do the job without adding to the public debt or risking distortionary intervention. This is my view, although I'll caution that a lot of it is self-taught (and not under the tutelage of bloggers - while I respect Paul Krugman and Scott Sumner, you'll notice that this is one area where I depart from both of them).
The New School for Social Research has a good page on the practical challenges to the liquidity trap here. This is what is known as the "real balances debate". Basically, deflation causes real balances to go up which combats liquidity preference. So the "liquidity trap" is self-correcting. At some point, I know Krugman actually worked out the real balance effect and demonstrated that it is minor. People don't get windfalls on assets from deflation. While there is some real balance effect, it isn't enough to correct the liquidity trap. I'm both writing that from memory and trusting his math on it, of course. Generally speaking I think the real balance effect is real, but probably minor. We just don't have the deflationary swings that we used to. And of course even if you get out of a liquidity trap, it doesn't mean demand isn't still depressed. You don't need a liquidity trap for depressionary conditions in a Keynesian model - the liquidity trap just ties one hand behind your back while you're fighting that depression!
UPDATE: Xenophon shares this critique of the liquidity trap. That reminded me I had two pieces of literature I wanted to share. This is a critique by Scott Sumner in the Cato Journal (I haven't read this in its entirety yet), and this is a good review of the history of the idea in History of Political Economy (I have read this), and this is Krugman's paper on the liquidity trap and Japan.