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A Monetary Analysis of the Liquidity Trap

Author

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  • João Braz Pinto

    (Deloitte Touche Tohmatsu Limited, Portugal)

  • João Sousa Andrade

    () (Faculty of Economics, University of Coimbra and GEMF, Portugal)

Abstract

Keynes has emphasized a particular situation in which the liquidity preference becomes absolute, leading to monetary policy ineffectiveness: the near zero nominal rate of interest does not allow negative values of the real interest rate. This situation is termed liquidity trap (LT) and although popularized by the IS-LM Hicks-Hansen framework it was authored by Robertson. It was also elected as the Keynesian case against the classical one. In 1998 Krugman recovered the name by applying it to the Japanese episode of the 1990's. The “lowflation” environment in USA and Europe brought again the LT to the forefront. The quantitative easing monetary policy was followed in Japan and is now applied in the USA and EMU as a solution to overcome the LT. But the LT has been erroneously considered as a money demand problem and at the same time denied as a “banking problem” in the words of Krugman. We contend that the current situation should be interpreted as a “banking problem” that impedes the transformation of the monetary base into money supply. In order to prove our thesis we study the behavior of the USA money multiplier and the income velocity of money before the beginning of the current crisis and during the crisis and by forecasting and estimating a VAR and a VECM model we compare the normal situation of monetary policy efficiency with the situation of LT monetary policy inefficiency.

Suggested Citation

  • João Braz Pinto & João Sousa Andrade, 2015. "A Monetary Analysis of the Liquidity Trap," GEMF Working Papers 2015-06, GEMF, Faculty of Economics, University of Coimbra.
  • Handle: RePEc:gmf:wpaper:2015-06.
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    File URL: http://www.uc.pt/feuc/gemf/working_papers/pdf/2015/gemf_2015-06
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    References listed on IDEAS

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    More about this item

    Keywords

    Liquidity Trap; Money Supply; Monetary Base Multiplier; ARIMA; VAR and VECM models.;

    JEL classification:

    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook

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