Some Reflections on the Theory of the “Liquidity Trap”

We provide a formal definition of the “liquidity trap” (LT) according to which, a LT arises if a combination of high precautionary saving, low investment and stringent conditions for access to bank credit stemming from a high degree of liquidity preference make the sum of the “neutral” interest rate and the expected inflation rate fall short of the term/risk premium on long-term interest rates. We then compare the “New Consensus” (NC) in macroeconomics as expounded in Woodford (2003) and the Post-Keynesian (PK) approach regarding the causes of a LT. We argue that in the NC approach a LT is a phenomenon caused by unusually large transitory shocks that depress the “neutral” interest rate temporarily. By contrast, we argue that in the PK approach an economy may also exhibit a “structural” or long-lasting LT even in the absence of large adverse shocks. Finally, we discuss a number of theoretical issues recently raised in the rapidly growing literature on the LT.