Academic journal article NBER Reporter

Macroeconomic Policy in a Liquidity Trap

Academic journal article NBER Reporter

Macroeconomic Policy in a Liquidity Trap

Article excerpt

The main focus of my research for nearly two decades has been macroeconomic policy during periods when the central bank has cut the short-term nominal interest rate to zero, periods that are often referred to as exhibiting a liquidity trap. In this summary, I describe my key conclusions.

The work can be divided quite neatly into four parts, roughly following the time line in which it was written. I highlight each phase of my research agenda and three generations of models which evolved along the way. While I focus primarily on my own research, I must acknowledge at the outset that many others have contributed to this research agenda.

First-Generation Models

My interest in the liquidity trap was triggered by events in Japan in the late 1990s. At that time, Japan suffered from subpar growth and deflation, and the short-term interest rate had collapsed to zero. If it could happen in Japan, it could happen here as well, and it seemed to me a first-order priority for those concerned with macroeconomic policy to understand those events.

My first published work on this topic was written with my adviser, Michael Woodford. (1) Central to it was the idea that once a central bank is constrained by the zero lower bound (ZLB), it can still have an impact on the economy by giving markets guidance about the evolution of future interest rates, rates that would prevail once the ZLB is no longer binding. For example, it could set explicit thresholds, saying that the interest rate will stay at zero until the price level or unemployment rate reaches a particular level, an idea we formalized in the paper. These results have received quite a bit of attention over the years, perhaps due to the fact that during the Great Recession the Federal Reserve used the analysis, and closely related work by other authors, as part of the rationale for its "forward guidance" policy once the ZLB became a concern. (2) Several other central banks--including the Bank of Canada, the European Central Bank, the Bank of Japan, and the Bank of England--utilized this research for similar policy purposes.

Another important result was an "irrelevance" proposition, the idea that increasing the money supply at a zero interest rate has no effect on output or prices if it does not change expectations about future interest rates. Woodford and I further showed that it was irrelevant how this was done, that is, which assets the central bank bought in order to increase the money supply. This was a quite controversial proposition when reported, but one that has stood the test of time, with several central banks more than doubling the monetary base during the most recent crisis, using various purchasing schemes, with little or no apparent effect on prices. (3) This was consistent with the empirical prediction of that paper. It was a direct violation, however, of the quantity theory of money, which was a reigning paradigm in the '90s.

A second major theme of my early work was how policies aimed at manipulating expectations, such as forward guidance, could be made credible. Specifically, I wanted to know what could be done by the government to back up an announcement of future intervention by the appropriate use of fiscal policy, exchange rate policy, or various forms of quantitative easing. This was the main focus of the paper, "The Deflation Bias and Committing to Being Irresponsible," the title of which played on Paul Krugman's proposal that the Bank of Japan needed to "commit to being irresponsible." (4) It was a theme I would return to repeatedly in work on the Great Depression in order to interpret various government policy actions in the 1930s, an agenda I took up after leaving graduate school at the urging of one of my advisers, Ben Bernanke, and many others.

The Great Depression and the Liquidity Trap

My work on the Great Depression yielded three major conclusions. First, it gave a somewhat novel interpretation of the U. …

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