Monetary Policy in a Liquidity Trap

By Dotsey, Michael | Business Review (Federal Reserve Bank of Philadelphia), Summer 2010 | Go to article overview

Monetary Policy in a Liquidity Trap


Dotsey, Michael, Business Review (Federal Reserve Bank of Philadelphia)


Monetary policy typically operates by targeting a short-term interest rate. For example, in the United States, the Federal Reserve targets the federal funds rate. In order to conduct monetary policy, central banks generally vary the short-term interest rate target in response to economic conditions. They do so because setting the short-term interest rate at a level consistent with economic fundamentals generally attains both the most efficient level of output (1) and an inflation rate consistent with long-run inflation objectives.

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This process usually involves lowering short-term interest rates when economic growth is weak or inflation or expected inflation is below some desired rate and raising them when the economy is growing strongly or when inflation or expectations of inflation are high. It has been theoretically shown in a wide class of economic models that conducting policy in this way allows the economy to employ resources efficiently. Low and stable inflation is a desirable feature of a well-managed economy, and setting the interest rate in a pro-cyclical manner is consistent with economic efficiency.

This way of conducting monetary policy is not just theoretically sound. Many empirical studies have shown that most central banks actually behave in this manner. This description of monetary policy--varying the interest rate in response to inflation and economic activity--is called a Taylor rule or a Taylor-type rule, named after John Taylor, who first described these types of policies.

In normal times it is fairly easy for the central bank to conduct policy according to a Taylor-type rule. But there is one instance when conducting policy in this manner becomes problematic: when the economy finds itself in a "liquidity trap," which is defined as a situation in which the short-term nominal interest rate is zero or very close to zero.

Because the nominal interest rate is generally bounded below by zero, the central bank cannot lower interest rates further even if it would be desirable to do so, as it would be if the economy were in a deep recession. Furthermore, as I'll discuss below, in this situation, trying to stimulate the economy by injecting more money or liquidity through open market operations may have little or no effect on output. Therefore, it may appear that monetary policy is impotent under these conditions.

This article analyzes the difficulties a central bank faces in such circumstances and discusses the tools available to monetary policymakers. Policy as usual is not an option, and the central bank's framework for conducting policy must change. Importantly, it must change in ways that alter individuals' expectations of what policy will be like when the zero lower bound on interest rates is no longer binding.

Thus, the conduct of monetary policy becomes quite subtle and depends on the credibility of proposed future actions. Further, economists have been concerned about the design of appropriate monetary policy in a liquidity trap for quite some time, and in what follows, I will draw heavily on the work of Gauti Eggertsson and Michael Woodford; Alan Auerbach and Maurice Obstfeld; and Paul Krugman.

ECONOMIC PROBLEMS ASSOCIATED WITH A LIQUIDITY TRAP

To understand the economic problems that ensue when an economy is in a liquidity trap, we must first understand the concept of the real interest rate and its role in efficiently allocating economic resources. What follows will be a fairly abbreviated analysis. (2)

The real interest rate, defined as the nominal interest rate less expected inflation, plays an important role in determining what fraction of output is consumed and what fraction is invested. In a perfectly competitive economy, the movement of the real interest rate in response to economic shocks is consistent with the optimal allocation of economic resources. That is, the real rate responds in such a way that the level of output and its allocation between consumption and investment is the one that provides the highest level of economic welfare. …

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