Macroeconomics

The Liquidity Trap

investment spending. A second possibility is that

monetary expansion could cause the currency to

lose value in the market for foreign-currency

exchange. This depreciation would make the

nation’s goods cheaper abroad, stimulating

export demand. (This mechanism goes beyond

the closed-economy IS–LM model we have used

in this chapter, but it fits well with the open-

economy version of the model developed in the

next chapter.) A third possibility is that the cen-

tral bank could conduct expansionary open-

market operations in a larger variety of financial

instruments than it normally does. For example,

it could buy mortgages and corporate debt and

thereby lower the interest rates on these kinds of

loans. The Federal Reserve actively pursued this

last option during the downturn of 2008.

Is the liquidity trap something monetary poli-

cymakers need to worry about? Might the tools

of monetary policy at times lose their power to

influence the economy? There is no consensus

about the answers. Skeptics say we shouldn’t

worry about the liquidity trap. But others say the

possibility of a liquidity trap argues for a target

rate of inflation greater than zero. Under zero

inflation, the real interest rate, like the nominal

interest, can never fall below zero. But if the nor-

mal rate of inflation is, say, 3 percent, then the

central bank can easily push the real interest rate

to negative 3 percent by lowering the nominal

interest rate toward zero. Thus, moderate infla-

tion gives monetary policymakers more room to

stimulate the economy when needed, reducing

the risk of falling into a liquidity trap.

5

5

To read more about the liquidity trap, see Paul R. Krugman, “It’s Baaack: Japan’s Slump and the

Return of the Liquidity Trap,” Brookings Panel on Economic Activity 2 (1998): 137–205.

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