It's Baaack: Japan's Slump and the Return of the Liquidity Trap

TLDR

The liquidity trap, a condition where monetary policy loses effectiveness because the nominal interest rate is essentially zero, has been a foundational concept in early macroeconomics, especially through Hicks’s IS‑LM model. The analysis uses Frankel’s fully identified model to assess the impact of monetary expansion. Frankel’s data indicate that a 1% increase in real GNP from monetary expansion reduces the current account by about 5.3% and the exchange rate by roughly 3%.

Abstract

s Slump and the Return of the Liquidity Trap THE LIQUIDITY TRAP-that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant because money and bonds are essentially perfect substitutes-played a central role in the early years of macroeconomics as a discipline.John Hicks, in introducing both the IS-LM model and the liquidity trap, identified the assumption that monetary policy is ineffective, rather than the assumed downward inflexibility of prices, as the central difference between Mr. Keynes and the classics.' It has often been pointed out that the Alice in Wonderland character of early Keynesianism-with its paradoxes of thrift, widows' cruses, and so on-depended on the explicit or implicit assumption of an accommodative monetary policy; it has less often been pointed out that in the late 1930s and early 1940s it seemed quite natural to assume that money was irrelevant at the margin.After all, at the end of the 1930s interest rates were hard up against the zero constraint; the average rate on U.S. Treasury bills during 1940 was 0.014 percent.Since then, however, the liquidity trap has steadily receded both as a memory and as a subject of economic research.In part, this is because in the generally inflationary decades after World War II nominal interest rates have stayed comfortably above zero, and therefore central banks have no longer found themselves "pushing on a string. ' Also, the experience of the 1930s itself has been reinterpreted, most notably by 1. Hicks (1937).137 Table 1.Second Year Effects on the U.S. Exchange Rate and Current Account after a Monetary Expansion to Raise Real GNP by 1 Percent Percent Modela Exchange rate Current accountb DRI -8.1 -0.02 EEC -4.0 -0.07 EPA -5.3 -0.03 LINK -2.3 -0.01 LIVERPOOL -39.0 -3.1 MCM -4.0 -0.05 MINIMOD -5.7 -0.07 MSG -6.7 -0.21 OECD -1.6 -0.13 VAR -7.6 -0.04 WHARTON -1.4 -0.17 Summary statistic Median -5.3 -0.03 Source: Frankel (1988).a. Models are fully identified by Frankel.