Liquidity Trap

2 Key excerpts on "Liquidity Trap"

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  eBook - ePub

  Macroeconomic Analysis in the Classical Tradition

  The Impediments Of Keynes's Influence

  • James C W Ahiakpor(Author)
  • 2021(Publication Date)
  • Routledge

    (Publisher)

  Treatise , Keynes defines investment as “the increased production of material wealth in the shape of capital-goods” (1930, 2: 207). Hawtrey (1950: 43) appropriately contrasts Keynes’s definition with its ordinary meaning: “acquisition of income-yielding securities or property, not Keynes’s sense of the accumulation of capital assets and unconsumed goods.” Keynes’s definition of investment is one reason he failed to appreciate the validity of the classical explanation that the supply of savings (demand for income-yielding securities) and investment-demand (supply of income-yielding securities) determine interest rates (inverse of the price of income-yielding securities). Besides, the funds employed in production (investment) include the classical wages fund and cash-on-hand, or “circulating capital.”

  13 Boianovsky (2004: 93) thus credits Hicks (1937) with too much originality with his claim that “Hicks based his formulation of the Liquidity Trap on the notion that the short-run nominal interest rate cannot be negative.”

  14 Keynes’s reference to debts of “long term” justifies Hicks’s explanation that Keynes always had the long-term rate of interest in mind in the liquidity-trap proposition. Current discussions of the Liquidity Trap in term of the US Fed’s operating in an environment of a zero lower bound of short-term rates and Boianovsky (2004) cited above thus appear to be inconsistent with Keynes’s own proposition.

  15 As Hawtrey (1933: 140) notes, “The currency in circulation in the United States rose [about one billion] from $4,598,000,000 in February, 1931, to $5,627,000,000 in February, 1932, while the depression was rapidly growing worse and the price level falling.” During this period three-month US Treasury bill rates actually rose: from 1.21% in February 1931 to 3.25% in December before falling to 2.65% in February 1932. The rate thereafter declined sharply to its lowest level of 0.08% in December 1932, rising again to 2.29% by March 1933 before declining to 0.10% in September. It rose to 0.69% in December 1933; see Table 8.1.

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  eBook - ePub

  Macroeconomics For Dummies

  • Dan Richards, Manzur Rashid, Peter Antonioni(Authors)
  • 2016(Publication Date)
  • For Dummies

    (Publisher)

  This problem occurs when the nominal interest rate is at or near zero, because the opportunity cost of holding cash is now nil. When you can’t earn a return on your funds anyway, you may as well hold them in cash. After all, cash is the most liquid of all assets, and when the nominal interest rate is zero, you can’t do better than cash anyway.

  In Figure 14-6 , the money supply is initially represented by m 0 , and the equilibrium nominal interest rate is already at approximately zero. (Between the end of 2008 and the end of 2015, the federal funds rate stayed consistently in the range of 0 to 0.25 percent.) In this case, increasing the money supply further to m 1 , say by open market operations, has no impact on the interest rate, because people are willing to hold unlimited cash if the nominal interest rate is essentially zero. Compare this to the situation in Figure 14-1 , where an increase in the money supply does result in a fall in the interest rate when there is no Liquidity Trap.

  © John Wiley & Sons, Inc.

  FIGURE 14-6: In a Liquidity Trap, increasing the money supply from m 0 to m 1 won’t lower the interest rate. It will stay at i 0 .

  Here’s another way of thinking about this situation: If nominal interest rates are below zero, that is, negative, and you give someone $10, sometime later he’d give you back less than $10. In other words, you’d be paying him for lending him money, which is crazy. You’d do better putting your cash under a mattress. So, once the nominal rate hits zero or near zero, it’s hard to see how it can go much lower.

  If you follow the news closely, you may smell a rat here. Highly unusually, recent years have seen a few cases where the nominal interest rate (yield) on some government bonds has been slightly negative. There are two reasons for these exceptions to the general rule. First, in the wake of repeated financial turmoil over recent years, banks have been holding a lot of excess reserves. In an effort to get banks to lend out those reserves instead and create loans that finance economic activity, some central banks have started to penalize such extra reserves by charging banks for holding them — by paying a negative return on reserves held at the central bank. For these banks, then, buying bonds that pay less than zero interest might still be better than holding their funds as reserves. An interest rate of minus 0.1 percent is still better than one of minus 0.2 percent.

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