THE LIQUIDITY TRAP, IN KEYNESIAN ECONOMICS , IS A SITUATION

WHERE MONETARY POLICY IS UNABLE TO STIMULATE AN ECONOMY , EITHER THROUGH LOWERING INTEREST RATES OR INCREASING THE MONEY SUPPLY . LIQUIDITY TRAPS TYPICALLY OCCUR WHEN EXPECTATIONS OF ADVERSE EVENTS (E.G., DEFLATION, INSUFFICIENT AGGREGATE DEMAND , OR CIVIL OR INTERNATIONAL

CONCEPTUAL EVOLUTION
In its original conception, a liquidity trap results when demand for money becomes infinitely elastic (i.e. where the demand curve for money is horizontal) so that further injections of money into the economy will not serve to further lower interest rates. Under the narrow version of Keynesian theory in which this arises, it is specified that monetary policy affects the economy only through its effect on interest rates. Thus, if an economy enters a liquidity trap, further increases in the money stock will fail to further lower interest rates and, therefore, fail to stimulate. In the wake of the Keynesian revolution in the 1930s and 1940s, various neoclassical economists sought to minimize the concept of a liquidity trap by specifying conditions in which expansive monetary policy would affect the economy even if interest rates failed to decline. Don Patinkin and Lloyd Metzler specified the existence of a "Pigou effect," named after English economist Arthur Cecil Pigou, in which the stock of real money balances is an element of the aggregate demand function for goods, so that the money stock would directly affect the "Investment Saving" curve in an ISLM analysis, and monetary policy would thus be able to stimulate the economy even during the existence of a liquidity trap. While many economists had serious doubts about the existence or significance of this Pigou Effect, by the 1960s academic economists gave little credence to the concept of a liquidity trap. The neoclassical economists asserted that, even in a liquidity trap, expansive monetary policy could still stimulate the economy via the direct effects of increased money stocks on aggregate demand. This was essentially the hope of the Bank of Japan in the 1990s, when it embarked upon quantitative easing. Similarly it was the hope of the central banks of the United States and Europe in 2008±2009, with their foray into quantitative easing. These policy initiatives tried to stimulate the economy through methods other than the reduction of short-term interest rates. When the Japanese economy fell into a period of prolonged stagnation despite near-zero interest rates, the concept of a liquidity trap returned to prominence.[1] However, while Keynes's formulation of a liquidity trap refers to the existence of a horizontal demand curve for money at some positive level of interest rates, the liquidity trap invoked in the 1990s referred merely to the presence of zero interest rates (ZIRP), the assertion being that since interest rates could not fall

However. both views have in common first the assertion that monetary policy affects the economy only via interest rates. by creating $600 billion and inserting this directly into banks. Stiglitz and others point out. monetary policy would prove impotent in those conditions.[2] In October 2010.below zero.[3] Stiglitz noted that the Federal Reserve intended. Stiglitz pointed out that banks were instead spending the money in more profitable areas by investing internationally in emerging markets. Nobel laureate Joseph Stiglitz explained how the U. may lead to currency wars while China redirects its currency holdings away from the United States. to spur banks to finance more domestic loans and refinance mortgages. While this later conception differed from that asserted by Keynes. . Much the same furor has emerged in the United States and Europe in 2008±2010. just as it was asserted to be in a proper exposition of a liquidity trap. Banks were also investing in foreign currencies which. and second the conclusion that monetary policy cannot stimulate an economy in a liquidity trap. as short-term policy rates for the various central banks have moved close to zero. ar) make persons with liquid assets unwilling to invest.S. Federal Reserve was implementing another monetary policy²creating currency²to combat the liquidity trap.

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