The Liquidity Trap
During the lengthy Great Depression of the 1930s, the nominal interest rate hit zero in the
United States, and the country found itself caught in what economists call a liquidity trap.
Recall from Chapter 15 that money is the most liquid of assets, unique in the ease with
which it can be exchanged for goods. A liquidity trap is a trap because once an economy’s
nominal interest rate falls to zero, the central bank cannot reduce it further by increasing the
money supply (that is, by increasing the economy’s liquidity). Why? At negative nominal
452 PART THREE Exchange Rates and Open-Economy Macroeconomics
interest rates, people would find money strictly preferable to bonds and bonds therefore
would be in excess supply. While a zero interest rate may please borrowers, who can borrow
for free, it worries makers of macroeconomic policy, who are trapped in a situation
where they may no longer be able to steer the economy through conventional monetary
expansion.
Economists thought liquidity traps were a thing of the past until Japan fell into one in
the late 1990s. Despite a dramatic lowering of interest rates by the country’s central bank,
the Bank of Japan (BOJ), the country’s economy has stagnated and suffered deflation
(a falling price level) since at least the mid-1990s. By 1999 the country’s short-term interest
rates had effectively reached zero. In September 2004, for example, the Bank of Japan
reported that the overnight interest rate (the one most immediately affected by monetary
policy) was only 0.001 percent.
Seeing signs of economic recovery, the BOJ raised interest rates slightly starting in
2006, but retreated back toward zero as a global financial crisis gathered force late in 2008
(see Chapter 19). That crisis also hit the United States hard, and as Figure 14-2 (page 333)
suggests, interest rates then plummeted toward zero in the United States as well as in
Japan. Simultaneously, other central banks throughout the world slashed their own rates
dramatically. The liquidity trap had gone global.
The dilemma a central bank faces when the economy is in a liquidity trap slowdown can
be seen by considering the interest parity condition when the domestic interest rate ,
Assume for the moment that the expected future exchange rate, , is fixed. Suppose the
central bank raises the domestic money supply so as to depreciate the currency temporarily
(that is, to raise today but return the exchange rate to the level later). The interest
parity condition shows that cannot rise once because the interest rate would have
to become negative. Instead, despite the increase in the money supply, the exchange rate
remains steady at the level
The currency cannot depreciate further.
How is this possible? Our usual argument that a temporary increase in the money supply
reduces the interest rate (and depreciates the currency) rests on the assumption that people
will add money to their portfolios only if bonds become less attractive to hold. At an interest
rate of , however, people are indifferent about trades between bonds and money—both
yield a nominal rate of return rate equal to zero. An open-market purchase of bonds for
money, say, will not disturb the markets: People will be happy to accept the additional money
in exchange for their bonds with no change in the interest rate from zero and, thus, no change
in the exchange rate. In contrast to the case we examined earlier in this chapter, an increase in
the money supply will have no effect on the economy! A central bank that progressively
reduces the money supply by selling bonds will eventually succeed in pushing the interest rate
up—the economy cannot function without some money—but that possibility is not helpful
when the economy is in a slump and a fall in interest rates is the medicine that it needs.
Figure 17-19 shows how the DD-AA diagram can be modified to depict the region of
potential equilibrium positions involving a liquidity trap. The DD schedule is the same,
but the AA schedule now has a flat segment at levels of output so low that the money market
finds its equilibrium at an interest rate equal to zero. The flat segment of AA shows
that the currency cannot depreciate beyond the level . At the equilibrium
point 1 in the diagram, output is trapped at a level that is below the full-employment
level Yf.
Y1
Ee/(1 - R*)
R
R = 0
E = Ee/(1 - R*).
E R = 0
E Ee
Ee
R = 0 = R* + (Ee - E)/E.
R = 0
CHAPTER 17 Output and the Exchange Rate in the Short Run 453
Exchange
rate, E
Y 1 Output, Y
1
DD
AA
Y f
Ee
1 – R *
Figure 17-19
A Low-Output Liquidity Trap
At point 1, output is below its
full employment level. Because
exchange rate expectations
are fixed, however, a monetary
expansion will merely shift AA
to the right, leaving the initial
equilibrium point the same.
The horizontal stretch of AA
gives rise to the liquidity trap.
Ee
Let’s consider next how an open-market expansion of the money supply works in this
strange, zero-interest world. Although we do not show it in Figure 17-19, that action
would shift AA to the right: At an unchanged exchange rate, higher output raises money
demand, leaving people content to hold the additional money at the unchanged interest
rate . The horizontal stretch of AA becomes longer as a result. With more money in
circlulation, real output and money demand can rise further than before without driving
the nominal interest rate to a positive level. (Eventually, as rises even further, increased
money demand results in progressively higher interest rates and therefore in progressive
currency appreciation along the downward-sloping segment of AA.) The suprising result is
that the equilibrium simply remains at point 1. Monetary expansion thus has no effect on
output or the exchange rate. This is the sense in which the economy is “trapped.”
Our earlier assumption that the expected future exchange rate is fixed is a key ingredient
in this liquidity trap story. Suppose the central bank can credibly promise to raise the
money supply permanently, so that rises at the same time as the current money supply.
In that case, the AA schedule will shift up as well as to the right, output will therefore expand,
and the currency will depreciate. Observers of Japan’s experience have argued, however,
that BOJ officials were so fearful of depreciation and inflation (as were many central
bankers during the early 1930s) that markets did not believe the officials would be willing
to depreciate the currency permanently. Instead, markets suspected an intention to restore
an appreciated exchange rate later on, and treated any monetary expansion as temporary.13
With the United States as well as Japan maintaining zero interest rates through 2010,
some economists feared that the Fed would be powerless to stop an American deflation
similar to Japan’s. The Fed as well as other central banks responded by adopting what
came to be called unconventional monetary policies, in which the central bank buys
Ee
R
Y
R = 0
Y
13This argument is made by Paul R. Krugman, “It’s Baaack: Japan’s Slump and the Return of the Liquidity
Trap,” Brookings Papers on Economic Activity 2 (1998), pp. 137–205. See also Ronald McKinnon and Kenichi
Ohno, “The Foreign Exchange Origins of Japan’s Economic Slump and Low Interest Liquidity Trap,” World
Economy 24 (March 2001), pp. 279–315.
454 PART THREE Exchange Rates and Open-Economy Macroeconomics
specific categories of assets with newly issued money. One such policy is to purchase
long-term government bonds so as to reduce long-term interest rates. Those rates play a
big role in determining the interest charged for home loans, and when they fall, housing
demand therefore rises. Another possible unconventional policy, which we will discuss in
the next chapter, is the purchase of foreign exchange.
SUMMARY
1. The aggregate demand for an open economy’s output consists of four components
corresponding to the four components of GNP: consumption demand, investment
demand, government demand, and the current account (net export demand). An important
determinant of the current account is the real exchange rate, the ratio of the foreign
price level (measured in domestic currency) to the domestic price level.
2. Output is determined in the short run by the equality of aggregate demand and aggregate
supply. When aggregate demand is greater than output, firms increase production
to avoid unintended inventory depletion. When aggregate demand is less than output,
firms cut back production to avoid unintended accumulation of inventories.
3. The economy’s short-run equilibrium occurs at the exchange rate and output level
where—given the price level, the expected future exchange rate, and foreign economic
conditions—aggregate demand equals aggregate supply and the asset markets are in
equilibrium. In a diagram with the exchange rate and real output on its axes, the shortrun
equilibrium can be visualized as the intersection of an upward-sloping DD schedule,
along which the output market clears, and a downward-sloping AA schedule, along
which the asset markets clear.
4. A temporary increase in the money supply, which does not alter the long-run expected
exchange rate, causes a depreciation of the currency and a rise in output. Temporary
fiscal expansion also results in a rise in output, but it causes the currency to appreciate.
Monetary policy and fiscal policy can be used by the government to offset the effects
of disturbances to output and employment. Temporary monetary expansion is powerless
to raise output or move the exchange rate, however, when the economy is in a
zero-interest liquidity trap.
5. Permanent shifts in the money supply, which do alter the long-run expected exchange
rate, cause sharper exchange rate movements and therefore have stronger short-run
effects on output than transitory shifts. If the economy is at full employment, a permanent
increase in the money supply leads to a rising price level, which ultimately
reverses the effect on the real exchange rate of the nominal exchange rate’s initial depreciation.
In the long run, output returns to its initial level and all money prices rise in
proportion to the increase in the money supply.
6. Because permanent fiscal expansion changes the long-run expected exchange rate, it
causes a sharper currency appreciation than an equal temporary expansion. If the economy
starts out in long-run equilibrium, the additional appreciation makes domestic
goods and services so expensive that the resulting “crowding out” of net export
demand nullifies the policy’s effect on output and employment. In this case, a permanent
fiscal expansion has no expansionary effect at all.
7. A major practical problem is ensuring that the government’s ability to stimulate the
economy does not tempt it to gear policy to short-term political goals, thus creating an
inflation bias. Other problems include the difficulty of identifying the sources or durations
of economic changes and time lags in implementing policies.
8. If exports and imports adjust gradually to real exchange rate changes, the current account
may follow a J-curve pattern after a real currency depreciation, first worsening
CHAPTER 17 Output and the Exchange Rate in the Short Run 455
and then improving. If such a J-curve exists, currency depreciation may have an initial
contractionary effect on output, and exchange rate overshooting will be amplified.
Limited exchange rate pass-through, along with domestic price increases, may reduce
the effect of a nominal exchange rate change on the real exchange rate.
During the lengthy Great Depression of the 1930s, the nominal interest rate hit zero in the
United States, and the country found itself caught in what economists call a liquidity trap.
Recall from Chapter 15 that money is the most liquid of assets, unique in the ease with
which it can be exchanged for goods. A liquidity trap is a trap because once an economy’s
nominal interest rate falls to zero, the central bank cannot reduce it further by increasing the
money supply (that is, by increasing the economy’s liquidity). Why? At negative nominal
452 PART THREE Exchange Rates and Open-Economy Macroeconomics
interest rates, people would find money strictly preferable to bonds and bonds therefore
would be in excess supply. While a zero interest rate may please borrowers, who can borrow
for free, it worries makers of macroeconomic policy, who are trapped in a situation
where they may no longer be able to steer the economy through conventional monetary
expansion.
Economists thought liquidity traps were a thing of the past until Japan fell into one in
the late 1990s. Despite a dramatic lowering of interest rates by the country’s central bank,
the Bank of Japan (BOJ), the country’s economy has stagnated and suffered deflation
(a falling price level) since at least the mid-1990s. By 1999 the country’s short-term interest
rates had effectively reached zero. In September 2004, for example, the Bank of Japan
reported that the overnight interest rate (the one most immediately affected by monetary
policy) was only 0.001 percent.
Seeing signs of economic recovery, the BOJ raised interest rates slightly starting in
2006, but retreated back toward zero as a global financial crisis gathered force late in 2008
(see Chapter 19). That crisis also hit the United States hard, and as Figure 14-2 (page 333)
suggests, interest rates then plummeted toward zero in the United States as well as in
Japan. Simultaneously, other central banks throughout the world slashed their own rates
dramatically. The liquidity trap had gone global.
The dilemma a central bank faces when the economy is in a liquidity trap slowdown can
be seen by considering the interest parity condition when the domestic interest rate ,
Assume for the moment that the expected future exchange rate, , is fixed. Suppose the
central bank raises the domestic money supply so as to depreciate the currency temporarily
(that is, to raise today but return the exchange rate to the level later). The interest
parity condition shows that cannot rise once because the interest rate would have
to become negative. Instead, despite the increase in the money supply, the exchange rate
remains steady at the level
The currency cannot depreciate further.
How is this possible? Our usual argument that a temporary increase in the money supply
reduces the interest rate (and depreciates the currency) rests on the assumption that people
will add money to their portfolios only if bonds become less attractive to hold. At an interest
rate of , however, people are indifferent about trades between bonds and money—both
yield a nominal rate of return rate equal to zero. An open-market purchase of bonds for
money, say, will not disturb the markets: People will be happy to accept the additional money
in exchange for their bonds with no change in the interest rate from zero and, thus, no change
in the exchange rate. In contrast to the case we examined earlier in this chapter, an increase in
the money supply will have no effect on the economy! A central bank that progressively
reduces the money supply by selling bonds will eventually succeed in pushing the interest rate
up—the economy cannot function without some money—but that possibility is not helpful
when the economy is in a slump and a fall in interest rates is the medicine that it needs.
Figure 17-19 shows how the DD-AA diagram can be modified to depict the region of
potential equilibrium positions involving a liquidity trap. The DD schedule is the same,
but the AA schedule now has a flat segment at levels of output so low that the money market
finds its equilibrium at an interest rate equal to zero. The flat segment of AA shows
that the currency cannot depreciate beyond the level . At the equilibrium
point 1 in the diagram, output is trapped at a level that is below the full-employment
level Yf.
Y1
Ee/(1 - R*)
R
R = 0
E = Ee/(1 - R*).
E R = 0
E Ee
Ee
R = 0 = R* + (Ee - E)/E.
R = 0
CHAPTER 17 Output and the Exchange Rate in the Short Run 453
Exchange
rate, E
Y 1 Output, Y
1
DD
AA
Y f
Ee
1 – R *
Figure 17-19
A Low-Output Liquidity Trap
At point 1, output is below its
full employment level. Because
exchange rate expectations
are fixed, however, a monetary
expansion will merely shift AA
to the right, leaving the initial
equilibrium point the same.
The horizontal stretch of AA
gives rise to the liquidity trap.
Ee
Let’s consider next how an open-market expansion of the money supply works in this
strange, zero-interest world. Although we do not show it in Figure 17-19, that action
would shift AA to the right: At an unchanged exchange rate, higher output raises money
demand, leaving people content to hold the additional money at the unchanged interest
rate . The horizontal stretch of AA becomes longer as a result. With more money in
circlulation, real output and money demand can rise further than before without driving
the nominal interest rate to a positive level. (Eventually, as rises even further, increased
money demand results in progressively higher interest rates and therefore in progressive
currency appreciation along the downward-sloping segment of AA.) The suprising result is
that the equilibrium simply remains at point 1. Monetary expansion thus has no effect on
output or the exchange rate. This is the sense in which the economy is “trapped.”
Our earlier assumption that the expected future exchange rate is fixed is a key ingredient
in this liquidity trap story. Suppose the central bank can credibly promise to raise the
money supply permanently, so that rises at the same time as the current money supply.
In that case, the AA schedule will shift up as well as to the right, output will therefore expand,
and the currency will depreciate. Observers of Japan’s experience have argued, however,
that BOJ officials were so fearful of depreciation and inflation (as were many central
bankers during the early 1930s) that markets did not believe the officials would be willing
to depreciate the currency permanently. Instead, markets suspected an intention to restore
an appreciated exchange rate later on, and treated any monetary expansion as temporary.13
With the United States as well as Japan maintaining zero interest rates through 2010,
some economists feared that the Fed would be powerless to stop an American deflation
similar to Japan’s. The Fed as well as other central banks responded by adopting what
came to be called unconventional monetary policies, in which the central bank buys
Ee
R
Y
R = 0
Y
13This argument is made by Paul R. Krugman, “It’s Baaack: Japan’s Slump and the Return of the Liquidity
Trap,” Brookings Papers on Economic Activity 2 (1998), pp. 137–205. See also Ronald McKinnon and Kenichi
Ohno, “The Foreign Exchange Origins of Japan’s Economic Slump and Low Interest Liquidity Trap,” World
Economy 24 (March 2001), pp. 279–315.
454 PART THREE Exchange Rates and Open-Economy Macroeconomics
specific categories of assets with newly issued money. One such policy is to purchase
long-term government bonds so as to reduce long-term interest rates. Those rates play a
big role in determining the interest charged for home loans, and when they fall, housing
demand therefore rises. Another possible unconventional policy, which we will discuss in
the next chapter, is the purchase of foreign exchange.
SUMMARY
1. The aggregate demand for an open economy’s output consists of four components
corresponding to the four components of GNP: consumption demand, investment
demand, government demand, and the current account (net export demand). An important
determinant of the current account is the real exchange rate, the ratio of the foreign
price level (measured in domestic currency) to the domestic price level.
2. Output is determined in the short run by the equality of aggregate demand and aggregate
supply. When aggregate demand is greater than output, firms increase production
to avoid unintended inventory depletion. When aggregate demand is less than output,
firms cut back production to avoid unintended accumulation of inventories.
3. The economy’s short-run equilibrium occurs at the exchange rate and output level
where—given the price level, the expected future exchange rate, and foreign economic
conditions—aggregate demand equals aggregate supply and the asset markets are in
equilibrium. In a diagram with the exchange rate and real output on its axes, the shortrun
equilibrium can be visualized as the intersection of an upward-sloping DD schedule,
along which the output market clears, and a downward-sloping AA schedule, along
which the asset markets clear.
4. A temporary increase in the money supply, which does not alter the long-run expected
exchange rate, causes a depreciation of the currency and a rise in output. Temporary
fiscal expansion also results in a rise in output, but it causes the currency to appreciate.
Monetary policy and fiscal policy can be used by the government to offset the effects
of disturbances to output and employment. Temporary monetary expansion is powerless
to raise output or move the exchange rate, however, when the economy is in a
zero-interest liquidity trap.
5. Permanent shifts in the money supply, which do alter the long-run expected exchange
rate, cause sharper exchange rate movements and therefore have stronger short-run
effects on output than transitory shifts. If the economy is at full employment, a permanent
increase in the money supply leads to a rising price level, which ultimately
reverses the effect on the real exchange rate of the nominal exchange rate’s initial depreciation.
In the long run, output returns to its initial level and all money prices rise in
proportion to the increase in the money supply.
6. Because permanent fiscal expansion changes the long-run expected exchange rate, it
causes a sharper currency appreciation than an equal temporary expansion. If the economy
starts out in long-run equilibrium, the additional appreciation makes domestic
goods and services so expensive that the resulting “crowding out” of net export
demand nullifies the policy’s effect on output and employment. In this case, a permanent
fiscal expansion has no expansionary effect at all.
7. A major practical problem is ensuring that the government’s ability to stimulate the
economy does not tempt it to gear policy to short-term political goals, thus creating an
inflation bias. Other problems include the difficulty of identifying the sources or durations
of economic changes and time lags in implementing policies.
8. If exports and imports adjust gradually to real exchange rate changes, the current account
may follow a J-curve pattern after a real currency depreciation, first worsening
CHAPTER 17 Output and the Exchange Rate in the Short Run 455
and then improving. If such a J-curve exists, currency depreciation may have an initial
contractionary effect on output, and exchange rate overshooting will be amplified.
Limited exchange rate pass-through, along with domestic price increases, may reduce
the effect of a nominal exchange rate change on the real exchange rate.
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