A Explanation of the Liquidity Trap in Wikipedia
The liquidity trap（流动偏好陷阱）, in Keynesian economics, is a situation where
monetary policy is unable to stimulate an economy, either through lowering interest
rates or increasing the money supply. Proponents claim liquidity traps typically occur
when expectations of adverse events (e.g., deflation, insufficient aggregate demand, or
civil or international war) make persons increase their liquidity preference. A
signature characteristic of the liquidity trap is the situation where short-term interest
rates are near zero and fluctuations in the monetary base fail to translate into
corresponding fluctuations in general price indices.
Conceptual evolution（概念演变）
In its original conception, a liquidity trap refers to the phenomenon when further
injections of money into the economy will not serve to further lower interest rates.
This can be visualized through a demand curve. Demand for money becomes
perfectly elastic (i.e. where the demand curve for money is horizontal). Under the
narrow version of Keynesian theory in which this arises, it is specified that monetary
policy affects the economy only through its effect on interest rates. Thus, if an
economy enters a liquidity trap, further increases in the money stock will fail to
further lower interest rates and, therefore, fail to stimulate.
In the wake of the Keynesian revolution in the 1930s and 1940s, various
neoclassical economists sought to minimize the concept of a liquidity trap by
specifying conditions in which expansive monetary policy would affect the economy
even if interest rates failed to decline. Don Patinkin and Lloyd Metzler specified the
existence of a "Pigou effect," named after English economist Arthur Cecil Pigou, in
which the stock of real money balances is an element of the aggregate demand
function for goods, so that the money stock would directly affect the "Investment
Saving" curve in an IS/LM analysis, and monetary policy would thus be able to
stimulate the economy even during the existence of a liquidity trap. While many
economists had serious doubts about the existence or significance of this Pigou Effect,
by the 1960s academic economists gave little credence to the concept of a liquidity
trap.
The neoclassical economists asserted that, even in a liquidity trap, expansive
monetary policy could still stimulate the economy via the direct effects of increased
money stocks on aggregate demand. This was essentially the hope of the Bank of
Japan in the 1990s, when it embarked upon quantitative easing. Similarly it was the
hope of the central banks of the United States and Europe in 2008–2009, with their
foray into quantitative easing. These policy initiatives tried to stimulate the economy
through methods other than the reduction of short-term interest rates.
When the Japanese economy fell into a period of prolonged stagnation despite
near-zero interest rates, the concept of a liquidity trap returned to prominence.
However, while Keynes's formulation of a liquidity trap refers to the existence of a
horizontal demand curve for money at some positive level of interest rates, the
liquidity trap invoked in the 1990s referred merely to the presence of zero interest
rates (ZIRP), the assertion being that since interest rates could not fall below zero,
monetary policy would prove impotent in those conditions, just as it was asserted to
be in a proper exposition of a liquidity trap.
While this later conception differed from that asserted by Keynes, both views
have in common first the assertion that monetary policy affects the economy only via
interest rates, and second the conclusion that monetary policy cannot stimulate an
economy in a liquidity trap. Declines in monetary velocity offset injections of short
term liquidity.
Much the same furor has emerged in the United States and Europe in 2008–2010,
as short-term policy rates for the various central banks have moved close to zero. Paul
Krugman argued repeatedly in 2008-11 that much of the developed world, including
the United States, Europe, and Japan, was in a liquidity trap. He noted that tripling of
the U.S. monetary base between 2008 and 2011 failed to produce any significant
effect on U.S. domestic price indices or dollar-denominated commodity prices.
In October 2010, Nobel laureate Joseph Stiglitz explained how the U.S. Federal
Reserve was implementing another monetary policy—creating currency—to combat
the liquidity trap. Stiglitz noted that the Federal Reserve intended, by creating $600
billion and inserting this directly into banks, to spur banks to finance more domestic
loans and refinance mortgages. However, Stiglitz pointed out that banks were instead
spending the money in more profitable areas by investing internationally in
commodities and the emerging markets. Banks were also investing in foreign
currencies which, Stiglitz and others point out, may lead to currency wars while China
redirects its currency holdings away from the United States.
Economist Scott Sumner has criticized the idea that Japan unsuccessfully
attempted expansionary monetary policy during the Lost Decade. Indeed, he claims
Japan's monetary policy was far too tight.
How Much Of The World Is In a Liquidity Trap?
Paul Krugman
As I’ve written many times in various contexts since the crisis began, being in a
liquidity trap reverses many of the usual rules of economic policy. Virtue becomes
vice: attempts to save more actually make us poorer, in both the short and the long run.
Prudence becomes folly: a stern determination to balance budgets and avoid any risk
of inflation is the road to disaster. Mercantilism works: countries that subsidize
exports and restrict imports actually do gain at their trading partners’ expense. For the
moment — or more likely for the next several years — we’re living in a world in
which none of what you learned in Econ 101 applies.
But what’s the definition of a liquidity trap? How much of the world is in one?
There’s a lot of confusion on that point; here’s how I see it.
In my analysis, you’re in a liquidity trap when conventional open-market
operations — purchases of short-term government debt by the central bank — have
lost traction, because short-term rates are close to zero.
Now, you may object that there are other things central banks can do, and that
they actually do these things to some extent: they can purchase longer-term
government securities or other assets, they can try to raise their inflation targets in a
credible way. And I very much want the Fed to do more of these things.
But the reality is that unconventional monetary policy is difficult, perceived as
risky, and never pursued with the vigor of conventional monetary policy.
Consider the Fed, which under Bernanke is more adventurous than it would have
been under anyone else. Even so, it has gone nowhere near engaging in enough
unconventional expansion to offset the limitations created by the zero lower bound.
A while back Goldman estimated that if it weren’t for the lower bound, the
current Fed funds rate would be minus 5 percent, and that to achieve the same effect
as a further 5 points of Fed funds cuts the Fed would have to expand its balance sheet
to $10 trillion; I wouldn’t stake my life on those estimates, but they seem in the right
ballpark. Obviously, the Fed isn’t doing that.
Or put it a different way: suppose the real economic outlook were the same as it
is — with all indications being that unemployment will stay very high for years to
come — but that the current Fed funds rate were, say, 4 percent. Clearly the Fed
would feel obliged to engage in a lot more expansion, cutting rates sharply and rapidly.
But with short-term rates at zero, the Fed is instead merely on hold — it is not
expanding its quantitative easing, and is in fact in the process of pulling back.
The point is that while you can think of things the Fed can do even at the zero
lower bound, that lower bound is in practice a major constraint on policy. By all
means let’s yell at the Fed to do more, but when you’re considering other issues —
like the effects of fiscal policy or the effects of renminbi undervaluation — you have
to assess them in terms of the central bank you have, not the central bank you wish
you had.
And by that criterion, how much of the world is currently in a liquidity trap?
Almost all advanced countries. The US, obviously; Japan, even more obviously; the
eurozone, because the ECB probably couldn’t engage in Fed-style quantitative easing
even if it wanted to, given the lack of a single backing government; Britain. Not
Australia, I guess. But still: essentially the whole advanced world, accounting for 70
percent of world GDP at market prices, is in a liquidity trap.