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The Liquidity Trap and the Pigou Effect: A Dynamic Analysis with Rational Expectations

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  • Bennett T. McCallum

Abstract

A Keynesian idea of considerable historical importance is that, in the presence of a liquidity trap, a competitive economy may lack--despite price flexibility--automatic market mechanisms that tend to eliminate excess supplies of labor. The standard classical counterargument, which relies upon the Pigou effect, has typically been conducted in a comparative-static framework. But, as James Tobin has recently emphasized, the more relevant issue concerns the dynamic response (in "real time") of an economy that has been shocked away from full employment. The present paper develops a dynamic analysis, in a rather standard model, under the assumption that expectations are formed rationally. The analysis permits examination of Tobin's suggestion that, because of expectational effects, such an economy could be unstable. Also considered is Martin J. Bailey's conjecture that, in the absence of a stock Pigou effect, Keynesian problems could be eliminated by expectational influences on disposable income.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0894.

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Date of creation: Apr 1984
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Handle: RePEc:nbr:nberwo:0894

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Cited by:
  1. C.A. Ullersma, 2001. "The Zero Lower Bound on Nominal Interest Rates and Monetary Policy Effectiveness: a Survey," MEB Series (discontinued) 2001-9, Netherlands Central Bank, Monetary and Economic Policy Department.
  2. Bennett T. McCallum, 1988. "The Role of Demand Management in the Maintenance of Full Employment," NBER Working Papers 2520, National Bureau of Economic Research, Inc.

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