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Escaping a Liquidity Trap: Keynes’ Prescription Is Right But His Reasoning Is Wrong


  • Harashima, Taiji


Keynes’ original intention in introducing the concept of a liquidity trap was to explain the reason why persistent large amounts of unutilized resources were generated during the Great Depression. This paper shows that this type of phenomenon cannot be explained in the framework of a traditional competitive market equilibrium. Instead, it can be understood in terms of a Nash equilibrium consisting of strategies of choosing a Pareto inefficient transition path because a Nash equilibrium can conceptually coexist with Pareto inefficiency. Such a Nash equilibrium will be selected when an upwards time preference shock occurs. At this Nash equilibrium, monetary policies are useless but fiscal policies are very effective as Keynes argued, but for different reasons.

Suggested Citation

  • Harashima, Taiji, 2013. "Escaping a Liquidity Trap: Keynes’ Prescription Is Right But His Reasoning Is Wrong," MPRA Paper 48115, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:48115

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    References listed on IDEAS

    1. Taiji Harashima, 2004. "The Ultimate Source of Inflation: A Microfoundation of the Fiscal Theory of the Price Level," Macroeconomics 0409018, EconWPA, revised 30 Mar 2005.
    2. Gary S. Becker & Casey B. Mulligan, 1997. "The Endogenous Determination of Time Preference," The Quarterly Journal of Economics, Oxford University Press, vol. 112(3), pages 729-758.
    3. Taiji Harashima, 2005. "The Cause of the Great Inflation: Interactions between the Government and the Monetary Policymakers," Macroeconomics 0510026, EconWPA, revised 17 Nov 2005.
    4. Olivier Jeanne & Lars E. O. Svensson, 2007. "Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank," American Economic Review, American Economic Association, vol. 97(1), pages 474-490, March.
    5. Anthony Downs, 1957. "An Economic Theory of Political Action in a Democracy," Journal of Political Economy, University of Chicago Press, vol. 65, pages 135-135.
    6. Gauti B. Eggertsson & Paul Krugman, 2012. "Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo Approach," The Quarterly Journal of Economics, Oxford University Press, vol. 127(3), pages 1469-1513.
    7. Paul R. Krugman, 1998. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 137-206.
    8. Gali, Jordi & Gertler, Mark, 1999. "Inflation dynamics: A structural econometric analysis," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 195-222, October.
    9. Taiji Harashima, 2004. "A More Realistic Endogenous Time Preference Model and the Slump in Japan," Macroeconomics 0402015, EconWPA, revised 09 Feb 2004.
    10. Harashima, Taiji, 2011. "A Mechanism of Cyclical Volatility in the Vacancy-Unemployment Ratio: What Is the Source of Rigidity?," MPRA Paper 32476, University Library of Munich, Germany.
    11. Harashima, Taiji, 2007. "The Optimal Quantity of Money Consistent with Positive Nominal Interest Rates," MPRA Paper 1839, University Library of Munich, Germany, revised 19 Feb 2007.
    12. Lawrance, Emily C, 1991. "Poverty and the Rate of Time Preference: Evidence from Panel Data," Journal of Political Economy, University of Chicago Press, vol. 99(1), pages 54-77, February.
    13. Jeff Fuhrer & George Moore, 1995. "Inflation Persistence," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 127-159.
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    Cited by:

    1. Harashima, Taiji, 2013. "The Phillips Curve and a Micro-foundation of Trend Inflation," MPRA Paper 51305, University Library of Munich, Germany.
    2. Harashima, Taiji, 2017. "Should a Government Fiscally Intervene in a Recession and, If So, How?," MPRA Paper 78053, University Library of Munich, Germany.
    3. Harashima, Taiji, 2016. "The Impending Long March of the Chinese Economy," MPRA Paper 73275, University Library of Munich, Germany.
    4. Harashima, Taiji, 2016. "The Cause of the Great Recession: What Caused the Downward Shift of the GDP Trend in the United States?," MPRA Paper 69215, University Library of Munich, Germany.

    More about this item


    Liquidity trap; Monetary policy; Fiscal policy; Pareto inefficiency; Time preference;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy

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