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Liquidity traps: how to avoid them and how to escape them

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  • Willem H Buiter
  • Nikolaos Panigirtzoglou

Abstract

An economy is in a liquidity trap when monetary policy cannot influence either real or nominal variables of interest. A necessary condition for this is that the short nominal interest rate is constrained by its lower bound, typically zero. The paper develops a small analytical model to show how an economy can get into a liquidity trap, how it can avoid getting into one and how it can get out. The empirical likelihood of the UK economy hitting the zero nominal rate bound is considered by investigating the relationship between the level of the short nominal interest rate and its volatility. The empirical evidence on this issue is mixed. To reduce the risk of falling into a liquidity trap, the authorities have two options. The first is to raise the inflation target. The second is to lower the zero nominal interest rate floor. This second option involves paying negative interest on government 'bearer bonds' - coin and currency - ie 'taxing money', as advocated by Gesell. Once in a liquidity trap, there are two means of escape. The first is to use expansionary fiscal policy. The second is, again, to lower the zero nominal interest rate floor. There are likely to be significant shoe leather costs associated with any scheme to tax currency.

Suggested Citation

  • Willem H Buiter & Nikolaos Panigirtzoglou, 2000. "Liquidity traps: how to avoid them and how to escape them," Bank of England working papers 111, Bank of England.
  • Handle: RePEc:boe:boeewp:111
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    JEL classification:

    • B22 - Schools of Economic Thought and Methodology - - History of Economic Thought since 1925 - - - Macroeconomics
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • N12 - Economic History - - Macroeconomics and Monetary Economics; Industrial Structure; Growth; Fluctuations - - - U.S.; Canada: 1913-
    • N13 - Economic History - - Macroeconomics and Monetary Economics; Industrial Structure; Growth; Fluctuations - - - Europe: Pre-1913
    • N14 - Economic History - - Macroeconomics and Monetary Economics; Industrial Structure; Growth; Fluctuations - - - Europe: 1913-

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