The Liquidity Trap and U.S. Interest Rates in the 1930s

Abstract

Most current literature assumes that a central bank loses the ability to influence interest rates through variations in reserve supply as soon as overnight rates have been driven to zero. I argue that reserve supply can be directly related to longer-term rates when overnight rates are zero because banks' reserve demand is then defined by the role of cash as an asset free of interest-rate risk. I present evidence that reserve supply affected longerterm interest rates in the U.S. from 1934 through 1939, while overnight rates were at the zero floor, even when the changes in reserve supply reflected factors unlikely to have affected expectations of future overnight rates.