Home > Macro/Monetary Theory, Uncategorized > It’s a Trap! A Liquidity Trap…

It’s a Trap! A Liquidity Trap…

Before I get deeper into this macro model, recall two main points from previous posts.  First, unexpected deflation is bad for the economy.  Second, an increase in the market interest rate causes the price of a durable asset to fall and the rate of change of that price to increase

Now a technical note on Fed policy.  Some people say that the Fed sets interest rates and some refer to this as changing the money supply.  I will imagine a model where the Fed chooses an interest rate and then people can borrow as much money as they want at that rate.  Thus if they lower the interest rate, the money supply will increase.  This is not different in any important way from imagining that they choose a quantity of money and this implies an interest rate (as in, for example, IS-LM) but it is a little easier to think of policy in these terms for this model and I would argue that it more closely approximates what the Fed actually does.

Begin by recalling how an economy with a fixed quantity of money (and flexible interest rate) would function.  The real rate of interest would be determined by real factors (intertemporal consumption preferences and investment opportunities), liquidity preference would cause the value of money to increase at a slower rate than other investments.  This would probably mean moderate deflation though inflation cannot be ruled out.  The difference between these two rates would be the nominal interest rate.  It is important to point out that all of these rates would be determined in the market.

Alternatively, consider an economy where some central authority chooses the nominal interest rate and the quantity of money is flexible (it expands/contracts to the point where that rate is an equilibrium in the market).  In this case, the real interest rate should still be determined by real factors.  This means that there will be an arbitrary fixed difference between the real and nominal interest rates.  In order for this to constitute an equilibrium in financial markets something else will have to adjust.  The natural variable that would resolve this is the inflation rate.  Let’s take a look at how that would happen.

Imagine an economy that produces one good which can either be consumed or invested to produce in the future.  And imagine it faces a number of investment opportunities for the production of that good with varying rates of return.  Naturally, they will participate in the most profitable investments first.  An efficient capital allocation would occur in an equilibrium where the marginal rate of substitution between consumption now and consumption in the future is equal to the rate of return on the marginal investment opportunity.  This rate would be the real interest rate.  All projects with a rate of return higher than this would be undertaken and all projects with rates of return below this would not. 

If a central authority set the interest rate at a level below the natural (nominal) rate. there would at first appear to be a bit of a paradox.  This is because investors, when faced with a lower interest rate would want to borrow more and invest in more projects until the marginal rate of return fell to that rate.  Meanwhile, consumers would want to borrow more (or lend less) until their marginal rate of substitution between consumption now and in the future fell to that level. 

If actors had perfect information, the market would still sort this out in an efficient way.  This is because the competing interests of investors and consumers would bid the price of the good in the present up through borrowing and inflating the money supply.  But in the future these loans would have to be paid back.  This will cause a contraction of the money supply in the future and if people can forsee this, they will expect prices to fall in the future.  In other words they will expect deflation and this deflation will pick up the slack between the real and nominal interest rates bringing the market into equilibrium with consumption and investment unchanged. 

The important thing to notice here is that the lower the nominal interest rate is set, the more deflation is required to bring the market into equilibrium.  This is contrary to the conventional wisdom which is that lowering the interest rate increases the money supply and therefore causes inflation in the long run but not in the short run because prices are sticky.  I suggest that this is only half the story.  In a frictionless economy with perfect information, prices would jump upward when interest rates are lowered.  Undoubtedly, this process takes some time in reality.  But it is premature to call the length of time that it takes for prices to adjust upward due to an increase in the money supply (from a lower interest rate) the “long run.”  In fact the period of inflation should be considered the medium run at best.  In the long run, this lowering of interest rates should actually cause deflation (or at least lower inflation). 

Now the problem is that the Fed tells us that it’s job is to simultaneously encourage growth with low interest rates and maintain a low but positive level of inflation.  Unfortunately, these are inherently incompatible.  Keeping the interest rate below its natural level causes pent-up deflationary pressure.  It does, however, cause inflation in the short run.  So as long as you have room left, when the inflation starts to turn to deflation you can lower rates more and the short run inflationary effects will offset the deflationary pressure that has been building up from previous low interest rates.  The rub is that you can’t lower interest rates below zero.  This is known as a liquidity trap.  Interestingly, this is the justification used by Keynes for advocating aggressive fiscal policy in a recession.  But to Keynesians, liquidity traps just sort of happen randomly.  I am arguing that they are a necessary effect of artificially low interest rates. 

Of course, when the Fed can no longer lower interest rates, they can no longer hold off the inflation that they had been baking in for years.  But if people don’t see this connection and continue to have faith in the Fed’s ability to keep infltion low, then when prices start to fall, firms and consumers will begin to default on their loans and it will cause all the effects noted in the post about deflation.

  1. W. Knowlton
    July 14, 2010 at 1:33 am

    This one gave me a mini “aha” moment.

    • Free Radical
      July 14, 2010 at 3:42 am

      Mini?! (=

  1. November 1, 2010 at 3:47 am

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