Wednesday, May 18, 2011

Some clarification on "liquidity traps"

Gary confuses liquidity preference theory and liquidity traps in the comment section of this post. I want to clear up exactly what we're talking about here, and why liquidity preference is very important (whereas liquidity traps are just an interesting curiosity).

Gary writes: "Daniel, While liquidity preference theory is not controversial amongst a subset of financial economists, how often it happens is. This was Milton Friedman's point; yeah, it is possible to get into a liquidity trap (though it is not very likely to ever occur), but to build your entire notion of economics around it (as Keynesians of all stripes do) is silly."

Liquidity preference theory says that one determinant of interest rates is the tradeoff that people make between holding and parting with liquidity. Keynes thought this was the determinant of interest rates. Most people since Keynes (myself included) think it is a determinant of interest rates, but not the only one. If liquidity preference is the only determinant of interest rate, there's no guarantee that the loanable funds market will clear or be consistent with full employment. If interest rates are determined jointly with the market for loanable funds, then the loanable funds market will clear but there's still no guarantee that it will be consistent with full employment.

That's the liquidity preference theory of the interest rate, but that has nothing at all to do with liquidity traps. You could firmly believe liquidity traps are impossible and still have a liquidity preference theory of the interest rate and a Keynesian perspective on the macroeconomy.

So then what's a liquidity trap? A liquidity trap is a situation where the demand for liquidity or money is virtually unlimited - where the money demand curve is highly elastic. Liquidity is in such high demand that no matter how much liquidity is pumped into the market, interest rates don't lower. The demand curve is not downward sloping, it is horizontal. People can't be satiated.

This is the traditional liquidity trap, at least. This is the version that Keynes speculated on briefly. Today, though, the liquidity trap has become associated with the "zero lower bound" thanks to Paul Krugman. In the 1990s, Krugman pointed out that in Japan a nominal interest rate floor acted like a horizontal money demand curve. You can think of the zero lower bound as a price floor in the market for liquidity. Money demand may not be horizontal at all, but the zero lower bound makes it look like we're in a region where it is. I've outline both of these situations (the traditional case and the Krugman case) below in red:

Most Keynesians are pretty skeptical of liquidity traps. We only think two have happened in U.S. history, with a few other cases in other countries. Here's the thing, though: all of these cases have been of the Krugman/ZIRP/faux-liquidity-trap variety. Keynes's original skepticism about a horizontal money demand curve seems to have held up pretty well. We're at the point now where the Krugman version is essentially taken to be synonymous with "liquidity trap" because it's the only version we ever see!

Liquidity traps are very bad news. I'm not of the opinion that they make monetary policy impossible. You can always create inflation with monetary policy, which lowers real interest rates even if nominal interest rates are stuck at zero. You can also do unconventional stuff like charge negative interest rates on reserves held at the Fed. However, it does make a much stronger case for fiscal policy. Creating inflation is hard in the current depressionary environment, so while in theory it's plausible to lower real interest rates that way it's a dicey proposition. Why mess with this horizontal money demand curve when we can increase public investments easily and when there are lots of worthwhile public investments to make? Why mess with a stubborn LM curve when the IS curve is easy enough to shift? So the liquidity trap/ZIRP situation is relevant to Keynesians insofar as it tips the scales in favor of fiscal policy. It has nothing to do with the broader Keynesian point about liquidity preference theory and the cause of the recessions.

A good source on this is Boinavosky (2004).

It's interesting - Krugman has been celebrated for his trade theory, but in the end he will probably be most remembered for permanently switching us from the old view of liquidity traps to the ZIRP view - first as it applied to Japan, and now as it applies to the U.S..


  1. Oh of course not.

    So if you didn't confuse them, then what did you mean by "how often liquidity preference theory happens"??

  2. The second clause of the first sentece was supposed to say "how often liquidity traps happens is." It was supposed to a transition from liquidity preference to liquidity traps. Yeah, I wrote it in an inartful and sloppy way; I'm exhausted from the house sale and all the stuff associated with that. How I write stuff will probably suffere as a result.

  3. Great - then we just have a good review of liquidity traps.

  4. I'm still not sure why you think anyone "builds their entire notion of economics" around liquidity traps (who does this exactly?), but we'll let that one be.

  5. And if you really must know, I hate sleeping in the day time, so I'll stay up all day and get some sleep tonight.

  6. Well, I didn't that Krugman's notion of liquidity traps differed from that of Keynes, so that was really helpful. Your distinction as to they differ isn't clear to me though.

    Because scratch and a Keynesian and they are always talking about liquidity traps. Or such is my experience.

  7. I was perusing Bill Woolsey's early Monetary Freedom post when I encountered this little gem (my italics):

    "As for the liquidity trap, it is almost certainly an artifact of 'conventional' monetary policy, particularly targeting interest rates, but also from limiting open market operations to Treasury bills. A commitment to adjust the quantity of money however much is needed to target nominal income implies a willingness to purchase longer term government bonds or even foreign bonds or private securities, if purchase of the entire outstanding stock of T-bills fails to do the job."

    This pretty much captures my view of the matter. Interest rates can be misleading in this context; it's all about the supply and demand for money -- not liquidity. In any case, while the case of fiscal policy is slightly stronger when the central bank is pushed to make unconventional asset purchases, the case is so poor to begin with that it makes hardly any difference. The list of conditions that would need to be satisfied before I would advocate fiscal stimulus is full of improbable and peculiar events.

  8. Daniel,

    No time to make the actual argument, but.. Open economony considerations, "negative" interest rates through foreign exchange calculations. You know, the normal MET critiques of the incredibly simpllstic Krugman Trap model that never seem to be actually addressed by people who talk about it.

    Ready... and Go.

  9. Aaron and Lee -
    Right - I mention the reasons for not thinking that the liquidity trap is the end of monetary adjustments, and we can include foreign exchange and open economy issues in this point as well. I'm not especially well qualified to comment on those issues, but I certainly am not oversimplifying the point or excluding them.

    Like I said - the liquidity trap is an interesting curiosity no matter how you think about it (in the old way or the new ZIRP way). The case for fiscal policy doesn't change with a liquidity trap - just its preferability relative to monetary policy (which would lose preferability with increasingly elastic money demand whether it was perfectly elastic or not).

  10. Hi Daniel,

    Could you elaborate a bit on your understanding of the mechanism by which liquidity preference affects interest rates? Also, what do you make of Nick Rowe's point about there not being a single "money market" cleared by the interest rate?



  11. Daniel: But surely the demand for money does flatten out at i =0? At even a slightly negative i, borrowing to increase one's money holdings would be profitable.

  12. Yes, that sounds right - so the little tail probably shouldn't be there.

    However, usually the zero lower bound is a reference to nominal rates. Presumably it would flatten out at i=0 for real rates. The point still stands, of course.

    And either way I think there's still an important distinction between the old idea of a horizontal demand for money - which seems quite unlikely - and an institutional/numeric situation of a zero lower bound - which seems much more plausible.

  13. Anonymous - I've racked my brain over this and I'm not sure how to answer you, but let me try.

    First I'll get the easy part of the answer out of the way: I've always agreed with Nick that money is the only good that's traded in all markets. This is what raises the whole concern about monetary disequilibrium, after all. When there is excess demand for money there will be excess supply of everything else, and you'll have a recession. I think Lee and Nick have been wrong to tie general gluts and recessions so exclusively together. You can have an excess demand for bonds and an excess supply of houses and that can sure feel like a recession even if it's not a general glut! But generally I agree on that point.

    What I have a harder time with is this idea that there is no market for money and that the interest rate isn't related to the supply and demand for money. Of course there's a market for money - granted, it's an intertemporal market. I can walk one block from my office to my bank and trade them the use of the money I have in my wallet for a particular price - the interest rate. Why do I keep the money in my pocket, then? Well, I like to stay a little liquid. If I wanted more liquidity I'd trade less for interest and if I wanted less liquidity I'd trade more for interest.

    Wait a minute, you say. That's just time preference! I'm trading money now for money in the future and setting that equal to my intertemporal discount rate.

    Maybe. But I also have money in CDs. I have some money in my savings account and some money in CDs, and I get a higher interest rate on the money I have in my CDs. We have been able to continually add to our savings in anticipation of making a down payment on a house, so I have ample funds both in the savings account and in the CD at all times. Time preference can't explain the differential between those two rates, then. After all, I have some money in my savings account for 12 months continuously, and I have some money sitting in my CD for the exact same 12 months. If it's just time preference, why does the deposit of the exact same amount of money for the exact same amount of time earn a different interest rate? It's because one is more liquid than the other.

    So increases in liquidity preference can increase interest rates. If liquidity preference increases but discount rates don't change then projects that were previously viable for investors are put off.

    I'm really not sure if that's a sensible way to put it or not. I usually just link to that DeLong post on interest rates. I think it's easy to talk about how liquidity preference influences interest rates (who cares about this point that money is traded in more than one market? - that's another issue entirely). It's also easy to talk about how two things determine bond prices: the demand and supply of bonds and the demand and supply of liquidity (the interest rate is the opportunity cost of holding cash), and the fact that those two can move in the opposite direction. This was DeLong's approach in that link. It seems to me that with those pieces you can point out how the time preference clearing interest rate isn't always the same as the liquidity preference clearing interest rate and that that differential can result in welfare loss.

  14. Assuming you're right Daniel, this was a great post. I am handicapped on this stuff because my college was staffed by free-market guys, and so I never learned the IS-LM stuff from somebody who believed it. (At NYU they didn't actually teach IS-LM because we were doing the Calvo models that Krugman says are only taught in bars.)

  15. bob - I think it's right, and I hope it's helpful. I have to ask, though - what is the connection between "free market guys" and not learning or having profs that accept IS-LM? I'm assuming perhaps you're using the term "free market guys" in a different way than I use it, but I should hope (for my sake, if nothing else) there's nothing a free market guy would find wanting in this particular analytic approach!

  16. Daniel,

    Thanks for the thoughtful reply. I think you are quite convincing that liquidity preference contributes to interest rates. My first impression is this makes liquidity preference one of the determinants of the supply of loanable funds. If that's the case, then I don't quite understand the whole overidentification point--i.e. that the interst rate is one price for two markets. What am I missing?


    (sorry about the "anonymous" tag above)


All anonymous comments will be deleted. Consistent pseudonyms are fine.