PDF | The theoretical analysis of Japan’s liquidity trap is developed by I think it is clear from the highlighted sections that Krugman is arguing. Must-Read: One thing that I find very interesting about Paul Krugman’s analysis of the liquidity trap and fiscal policy back in is how very. But I gather that some readers are confused – haven’t I been arguing that monetary policy is ineffective in a liquidity trap? The brief answer is.
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EconPapers: Thinking About the Liquidity Trap
Some economists such as a Nobel Laureate Paul Krugman are of the view that if the US were to fall into liquidity trap the US central bank should aggressively pump money and aggressively lower interest rates in order to lift the trao of inflation. This Krugman holds will pull the economy from the liquidity trap and will set the platform for an economic prosperity.
In his New York Times article of January 11,he wrote. If nothing else, we’ve learned that the liquidity trap is neither a figment of our imaginations nor something that only happens in Japan; it’s a very real th, and trp and when it ends we should nonetheless be guarding against its return — which means that there’s a very strong case both for a higher inflation target, and for aggressive policy But does it make sense that by means of more inflation the US economy could be pulled out of the liquidity trap?
In the popular framework of thinking that originates from the writings of John Maynard Keynes, economic activity presented in terms of a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual’s earnings.
Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reasons — have decided to cut down on their expenditure and raise their savings. For instance, if for some reason people thunking become less confident about the future, they will cut back on their outlays and hoard more money. Therefore, once an individual spends less, this worsens the situation of some other aabout, who in turn also cuts his spending.
A vicious circle sets in: Following this logic, in order to prevent a recession from getting out of hand, the central bank must lift the money supply and aggressively lower interest rates.
Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby re-establishing the circular flow of money, so it is held. In his writings, however, Abouy suggested that a situation could emerge when an aggressive lowering of interest rates by the central bank thinnking bring rates to a level from which they would not fall further.
This, according to Keynes, could occur because people might adopt a view that interest rates have tap out and that rates should subsequently rise, leading to capital losses on bond holdings. As a result, people’s demand for money will become extremely high, implying that people would hoard liquidihy and refuse to spend it no matter how much the central bank tries to expand the money supply. There is the possibility, for the reasons discussed above, that, after the rate of krugmna has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest.
In krugjan event the monetary authority would have lost effective control over the rate of interest. Keynes suggested that, once a low-interest-rate policy becomes ineffective, authorities should step in and spend. The spending can be on all sorts of projects — what matters here is that a lot of money must be pumped, which is expected to boost consumers’ confidence.
With a higher level of confidence, consumers will lower their savings and raise their expenditure, thereby re-establishing the circular flow of money.
In the Keynesian framework the ever-expanding monetary flow is the key to economic prosperity. What drives economic growth is monetary expenditure.
When people spend more of their money, this is seen as saving less. Observe that in the popular — i. The liquidity trap comes from too much saving and the lack of spending, so it is held. However, to suggest that people could have an unlimited demand for money hoarding money that supposedly leads to a liquidity trap, as popular thinking jrugman it, would imply that no one would be exchanging goods.
Obviously, this is not a realistic proposition, given the fact that people require goods to support their lives and krugma. Being the medium of exchange, money can only assist in exchanging the goods of one producer for the goods of another producer. Saving is the first step on the way toward improvement of material well-being and toward every further progress on this way.
As long as the rate of growth of the pool of real savings stays positive, this can continue to sustain productive and non-productive activities. Trouble erupts, however, when, on account of loose monetary and fiscal policies, a krugmman of production emerges that ties up much more consumer goods than the amount it releases.
This excessive consumption relative to the production of consumer goods leads to a decline in the pool of real savings.
This in turn weakens the support for economic activities, resulting in the economy plunging into a slump. The shrinking pool of real savings exposes the commonly accepted fallacy that the loose monetary policy of the central bank can grow the economy.
Once the jrugman falls into a recession because of a falling pool of real saving, any government or central bank attempts to revive the economy must fail. Not only will these attempts not revive the economy; they will deplete the pool of real savings further, thereby prolonging the economic slump. Likewise, any policy that forces banks to expand lending “out of thin air” will further damage liquidjty pool and will reduce further banks’ ability to lend.
Note that the essence of lending is real savings and not money as such. Real savings impose restrictions on banks’ ability to lend.
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Money is just the medium of exchange, which facilitates real savings. Also, note that without an expanding pool of real savings any expansion of bank lending is going to lift banks’ nonperforming assets.
Contrary to Krugman, we suggest that if the US economy were to fall into a liquidity trap the reason for that is not a sharp increase in the demand for money, but because loose monetary policies have depleted the pool of real savings. What is required in this case is not to generate more inflation but the exact opposite.
Setting a higher inflation target, as suggested by Krugman, will only weaken the pool of real savings further and will guarantee that the economy will stay in a depressed state for a prolonged time.
Frank Shostak ‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. View the discussion thread.
Skip tyinking main content. In his New York Times article of January 11,he wrote, If nothing else, we’ve learned that the liquidity trap is neither a figment of our imaginations nor something that only happens in Japan; it’s a very real threat, and if and when it ends we should nonetheless be guarding against its return — which thinkign that there’s a very strong case both for a higher inflation target, and for aggressive policy The Origin of the Liquidity-Trap Concept In the popular framework of thinking that originates from the writings of John Maynard Keynes, economic activity presented in terms of a circular flow of money.
Keynes wrote, There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest.
Do Individuals Save Money? Likewise, a change in the supply of money doesn’t have any power to grow the real economy.