Liquidity Trap Research Articles

What Kind Of Inflation Targeting Is Considered The Most Accepted In The Eu Economies?

This study aims to identify the optimal inflation target for the European Central Bank (ECB). It will argue that the current definition of price stability and thus, the target of 2% yearly increase in HICP is not relevant according to our macroeconomic projection in Eurozone. This study argues that very low inflation rates for the last years may signify a threat of deflation. Specifically, the study argues for asymmetric inflation targeting and recommend the ECB to reformulate its inflation target as “close to 2.5% from below and above”. This has to be done in order to counter possible deflation, lower unemployment, avoid the liquidity trap, and give more room for the ECB to conduct its macroeconomic policy under the threat of recession. It is also briefly illuminated some other benefits of higher inflation, such as the option of negative interest rates, seigniorage and money illusion, and the corresponding of the costs associated with higher inflation of 2.5%, such as shoe leather costs, menu costs, tax distortions and uncertainty due to price variability. It is assumed that the outcome of Cost-Benefit analysis for a 2.5% inflation target is not very different from that for a 2% level, while a greater increase in inflation target would produce unclear results.

Czy największe gospodarki świata znajdują się w pułapce płynności?

Wpadnięcie kraju w pułapkę płynności oznacza brak skuteczności ekspansywnej polityki pieniężnej banku centralnego mającej na celu zwiększenie popytu konsumpcyjnego i inwestycyjnego w kraju. Sytuacja ta wynika z tego, że uczestnicy rynku (gospodarstwa domowe i przedsiębiorstwa) zamiast zwiększać popyt, akumulują rosnącą podaż pieniądza w postaci gotówki. Keynes twierdził, że dla gospodarki znajdującej się w pułapce płynności jedynym sposobem na zwiększenie popytu w kraju i na pobudzenie koniunktury gospodarczej jest prowadzenie ekspansywnej polityki fiskalnej w postaci zwiększenia wydatków rządowych lub zmniejszenia podatków. Celem podjętych badań jest próba wersyfikacji empirycznej hipotezy pułapki płynności w trzech największych gospodarkach na świecie, tzn. w USA, strefie euro i Japonii po kryzysie finansowym z 2008 r. W artykule wykorzystano metodę badawczą opartą na studiach literaturowych z zakresu makroekonomii i finansów oraz metody statystyczne. Wszystkie wykorzystane w pracy dane statystyczne pochodziły z urzędu statycznego Unii Europejskiej – EUROSTAT oraz z bazy statycznej Konferencji Narodów Zjednoczonych do spraw Handlu i Rozwoju – UNSTATS.

TAX RULES TO PREVENT EXPECTATIONS-DRIVEN LIQUIDITY TRAPS

Multiple equilibria arise in standard New Keynesian models when the nominal interest rate is set according to the Taylor rule and constrained by a zero lower bound (ZLB). One of these equilibria is deflationary and referred to as an expectations-driven liquidity trap (ELT) as it arises because of the de-anchoring of inflation expectations. This study demonstrates that a simple tax rule responding to inflation can prevent a liquidity trap from arising without increasing government spending or debt. We analytically investigate the necessary and sufficient conditions to prevent an ELT and show that both the frequency and persistence of ELT episodes affect the extent to which the tax rule must respond to inflation. In brief, the higher the frequency or the longer the persistence of the ELT, the greater the response of the tax rate must be.

Can central banks run out of ammunition? The role of the money‐equities‐interaction channel in monetary policy

AbstractMany authorities claim that central banks ‘have run out of ammunition’, either because the central bank rate has dropped close to the zero lower bound or because of Keynes's liquidity trap. I argue first, that indefinitely large increases in the quantity of money remain possible even with the central bank rate close to zero, and, second, that increases in the quantity of money raise all asset prices, including the prices of quoted equities, not just bond prices. Bonds are an unimportant asset class in modern capitalist economies, relative to corporate equity and real estate. Meanwhile increases in equity prices always boost aggregate demand and output.

On Public Spending and Economic Unions

We analyze the conduct of fiscal policy in a financially integrated union in the presence of financial frictions. Frictions create a wedge between the return to investment and the union interest rate. This leads to an over-spending externality. While the social cost of spending is the return to investment, governments care mostly about the (depressed) interest rate they face. In other words, the crowding-out effects of public spending are partly “exported” to the rest of the union. We argue that it may be hard for the union to deal with this externality through the design of fiscal rules, which are bound to be shaped by the preferences of the median country and not by efficiency considerations. We also analyze how this overspending externality—and the union’s ability to deal with it effectively—changes when the union is financially integrated with the rest of the world. Finally, we extend our model by introducing a zero lower bound on interest rates and show that, if financial frictions are severe enough, the union is pushed into a liquidity trap and the direction of the spending externality is reversed. At such times, fiscal rules that are appropriate during normal times might backfire.

Liquidity Traps in a World Economy

This paper studies a New Keynesian model of a two-country world with a zero lower bound (ZLB) constraint for nominal interest rates. A floating exchange rate regime is assumed. The presence of the ZLB generates multiple equilibria. The two countries can experience recurrent liquidity traps induced by the self-fulfilling expectation that future inflation will be low. These “expectations-driven” liquidity traps can be synchronized or unsynchronized across countries. In an expectations-driven liquidity trap, the domestic and international transmission of persistent shocks to productivity and government purchases differs markedly from shock transmission in a “fundamentals-driven” liquidity trap.

Monetary policy effectiveness in the liquidity trap: a switching regimes approach

Liquidity trap economics seems to have fared particularly well on all counts of its predictions, in the aftermath of the 2008 global financial crisis. Therefore, in this paper we evaluate formally the effectiveness of unconventional monetary policy in a liquidity trap, based on data from Japan, the USA, and the eurozone over periods of liquidity trap conditions (1994–2018 for Japan and 2009–2018 for the USA and the eurozone). Under effective unconventional policies, changes in the base money-growth regime should be associated with similar regime changes in either inflation or investment expenditure growth and the estimation of a switching regimes model allows us to test whether significant joint regime shifts occur in the data. Also, a test of liquidity trap conditions is based on a discrepancy of regime shifts between growth rates of base money and broad money, since this implies a collapse of the money multiplier. Our findings show that drastic shifts in the growth rate of the monetary base do not produce similar behavior for the inflation rate, investment expenditure growth, and broad money growth, thus pointing to liquidity trap conditions and unconventional monetary policy ineffectiveness.

Unemployment Risk, Liquidity Traps, and Monetary Policy

When the economy is in a liquidity trap and households have a precautionary motive to save against unemployment risk, adverse demand shocks cause severe deflationary spirals and output contractions. In this context, we study the implications of optimal monetary policy, which consists of keeping the nominal rate at zero longer than implied by current macroeconomic conditions. Under such policy and incomplete markets, expected improvements in labour market conditions mitigate the rise in unemployment risk and decline in demand. As a result, market incompleteness may alleviate contractions in output and inflation during a liquidity trap. However, reducing market incompleteness mitigates the fall in demand under realistic monetary policy rules.

'Captivated by Liquidity' – Theoretical Traps and Practical Mazes

There is no uniform theoretical standpoint on the effects of changing interest rates and the role of money among economists. Though these disputes exercise a great influence on the economic policy measures adopted as well. For the management of the 2008 global financial crisis many central banks entered into forceful interest rate cuts to contribute to the revitalisation of the economy. The economic recession caused by the pandemic of 2020 again raises the issue how central banks can stimulate growth. In this study we deal with the liquidity trap issue attributed to Keynes. Keynes pointed out that there might exist a lower interest rate limit under which money demand becomes infinite. His conceptions put the foundations to the question, at what interest rate levels might the liquidity trap – a term coined later by Robertson – phenomenon become effective. He was followed by numerous renowned economists dealing with the conception. In this paper we are discussing the most important theoretical approaches – among others the views of Hansen, Hicks, Tobin, Patinkin, Krugman, Brunner and Meltzer and Eggertson. We provide an overview on the effects of low interest rate levels adopted by Japan, by the central banks of Japan, the USA and the ECB aimed at stimulating the economy. Based on the study it can be confirmed that central banks can contribute to economic growth keeping interest rates low and therewith fostering investment. Nevertheless, beyond keeping short-term interest rates low, it might be adequate to control interest rates of other maturities and, especially under deflationary expectations, central banks should express their prolonged commitment to low interest rates.

Макроэкономическая политика на перепутье

The article examines macroeconomic policy options for advanced economies to respond to adverse shocks in the environment of very low interest rates and very high levels of public debt, when the scope for using conventional policy tools is limited. The standard transmission mechanism of monetary policy in the ELB conditions stops working normally, and the economy faces the “liquidity trap” effect. The deployment by central banks of unconventional monetary tools (forward guidance, quantitative easing, and negative interest rates) after global financial crisis was helpful in combatting the downturn, but carries risk of possible side effects. Large-scale purchases of financial assets lead to significant increase in central banks’ balance sheets, and this creates a threat to future financial stability and central bank independence. Negative interest rates can have detrimental effects on bank profitability and be contractionary through bank lending. There is a consensus that today fiscal policy has to play a major role in stabilizing the business cycle. But the effectiveness of conventional tools of discretional fiscal policy is uncertain because of long political lags and small spending multiplier. Existing automatic fiscal stabilizers are focused on social protection goals and not on macroeconomic stabilization. Thus, the newly proposed measures for rules-based fiscal stimulus (asymmetric semiautomatic stabilizers – tax or spending measures triggered by the crossing of some statistical threshold, e.g. a high unemployment rate) and unconventional fiscal policy (the use of consumption taxes to increase inflation expectations) have become the object of active discussion. Here lies the danger in the fusion of monetary and fiscal policy: central banks’ operations are becoming increasingly quasi-fiscal, aimed at financing budget deficit, and functions of monetary policy are proposed to assign to fiscal policy. Besides, the expansion of fiscal stimulus threatens financial stability in the future, as it leads to increase in public debt and narrows a country’s fiscal space.

Slow recoveries, endogenous growth and macroprudential policy

Banking crises have severe short and long‑term consequences. We develop a general equilibrium model with financial frictions and endogenous growth in which macroprudential policy supports economic activity and productivity growth by strengthening bank’s resilience to adverse financial shocks. The improved intermediation capacity of a safer banking system leads to a higher steady state growth rate. The optimal bank capital ratio of 18% increases welfare by 6.7%, 14 times more than in the case without endogenous growth. When the economy enters a liquidity trap, the effects of financial disruptions and thus the benefits of macroprudential policy are even more significant.

THE STUDY ON THE LIQUIDITY TRAP IN CHINA’S MONEY MARKET

This study aims to identify the liquidity trap and indicate the factors that affect money liquidity in China. A liquidity trap is an economical issue which is faced by lots of developed countries when their economy has achieved a certain stage of development, such as Japan, America and Europe. However, China as the fastest-growing developing country, some scholars suggested that its economy has also being trapped in a liquidity trap. Thus, to verify this opinion, monthly data of several important economic indexes were selected through a series of econometric process to indicate two major findings. First, the economy of China has not fallen into a liquidity trap. Besides, the interest rate and real estate price had a negative impact on the liquidity of money in China while the development of the financial industry had a positive contribution.

Managing Expectations: Instruments Versus Targets

AbstractShould policy communications aim at anchoring expectations of the policy instrument (“keep interest rates at zero until date τ”) or of the targeted outcome (“do whatever it takes to bring unemployment down to $y\%$”)? We study how the optimal approach depends on a departure from rational expectations. People have limited depth of knowledge and rationality, or form otherwise distorted beliefs about the behavior of others and the general equilibrium (GE) effects of policy. The bite of this distortion on implementability and welfare is minimized by target-based guidance if and only if GE feedback is strong enough. This offers a rationale for why central banks should shine the spotlight on unemployment when faced with a prolonged liquidity trap, a steep Keynesian cross, or a large financial accelerator.

LIQUIDITY TRAP IN THE UNITED STATES, THE EURO AREA AND JAPAN

When a country falls into a liquidity trap it means that its central bank lacks an effective expansionary monetary policy aimed at increasing consumption and investment demand. Market participants (households and enterprises), instead of increasing demand, accumulate a growing money supply in the form of cash. Keynes argued that for an economy in a liquidity trap, the only way to increase demand in the country and to stimulate the economy is to conduct expansionary fiscal policy by increasing government spending or reducing taxes. The aim of the research is to verify the empirical hypothesis of the liquidity trap in three of the largest economies in the world, formerly known as the Global Triad (i.e. the USA, the euro zone and Japan), after the 2008 financial crisis. Research methods based on literature studies in macroeconomics and finance, as well as statistical methods, were used in the study. All statistical data came from the statistical office of the European Union – EUROSTAT, and from the statistical database of the United Nations Conference on Trade and Development - UNCTADstat.

Apocalypse Averted: The COVID‐Caused Liquidity Trap, Dodd‐Frank, and the Fed

In an article published in this journal in 2012, the author challenged the conventional wisdom that a major feature of Dodd‐Frank—the mandated clearing and required margining of OTC derivatives—could be expected to achieve a material reduction of the risk of another financial crisis. In this article, the author views the dramatic financial fallout from the spread of COVID‐19 in March 2020, when the economic infrastructure of the U.S. was threatened by extreme disruptions in its stock and bond markets, as providing the first major test of this theory.The author's main conclusion from this episode is that the very mechanism that advocates of Dodd‐Frank claimed would reduce systemic risk—the clearing of and imposition of margin requirements on derivatives—played a major role in this acute market dislocation by amplifying stresses on and dramatically reducing market liquidity.One major implication of this analysis is that protecting important pieces of the system, such as clearinghouses, is not the same as protecting the entire system; indeed, these two goals are likely to prove to be antithetical under conditions of stress. It was only massive injections of liquidity by the Federal Reserve, and not the autonomous operation of the market infrastructure mandated by Dodd‐Frank, that succeeded in stemming the crisis. And as this case is meant to suggest, despite clearing mandates and other major regulatory changes designed to minimize systemic risk, the net effect has been to substitute possibly greater liquidity risks for credit risk. As a consequence, the soundness of the U.S. financial system continues to depend on the prompt and effective intervention of the Fed as lender of last resort, with all the attendant moral hazard problems.

Monetary Policy Inertia, Macroprudential Policy, and Financial Stability in a Liquidity Trap

After the colossal financial crisis of 2008, many monetary policy analyses have shown the profound implications for financial stability of monetary policy in a liquidity trap. This paper investigates how monetary policy in a liquidity trap affects financial stability in a New Keynesian model incorporating a financial friction. The main findings are as follows: A strong financial stabilization policy is effective in mitigating an excess expansion of credit in normal times. However, this same stabilization policy expands credit when the economy is in a liquidity trap. These findings show that the effectiveness of financial stabilization policy can vary depending on whether or not the economy is in a liquidity trap.

Monetary Policy Inertia and the Paradox of Flexibility

This paper revisits the paradox of flexibility, i.e., the result that, in a liquidity trap, greater price flexibility amplifies output volatility in response to negative demand shocks. We argue this paradox is the consequence of a failure of standard models to correctly characterize monetary policy and that allowing for a smooth adjustment of the shadow policy rate eliminates the paradox and produces output responses to a negative demand shock that are in line with those under optimal monetary policy. The reason is that, under an inertial policy, a decline in the shadow rate implies that the future actual policy rate will remain relatively low, which increases expectations about the economic outlook and inflation. The rise in inflation expectations reduces the real rate, thereby sustaining real activity. As we raise the degree of price flexibility, a negative demand shock causes a sharper fall in the shadow rate and increase in inflation expectations, which leads to a more significant drop in the real rate and, hence, a milder decline in the output gap.

“Institutional Trap”: Both a Productive Concept and a Fine Metaphor

This paper is a reaction to the polemical article by Andrei Vernikov, How much substance is there behind the concept of Trap? (Journal of Institutional Studies, 2020, 12(2), pp. 25–37). This article concludes that there is no necessary scientific rigor and constructiveness of the concept of (IT), and therefore it is proposed to introduce a kind of academic ostracism in the form of a scientific moratorium on this concept in the form of its ban on the pages of academic journals and in the programs of training courses. The proposed article shows that the term IT has all the properties of strictness when defined at the verbal, i.e. the most generalized, level. At the same time, it is demonstrated that when switching to specific model constructions, the concept of IT acquires mathematical rigor and applied operationality, which is confirmed by a large number of IT models developed in Russia and abroad. The article also refutes A. Vernikov's Lemma, according to which there is no economic or social phenomenon in modern Russia that cannot be declared an trap. This is done using such striking counterexamples as the liquidity trap and the Malthusian trap, which do not fall under the definition of IT. Special attention is paid to identifying differences in terms of IT, Institute dysfunction and lock-in effect. Typical errors in the use of the term IT are demonstrated and it is proved that the fault for this lies with the authors who produce errors, and not with the term that does not contain any specific flaws. The thesis is put forward that the purity of the terminological field of institutional analysis should be provided by the expert community at the stage of reviewing articles, and not by methods of prohibiting scientific concepts. It is concluded that the popularity of the term IT is due to the fact that it is both a strict scientific concept and a beautiful metaphor.

Quantitative easing impotence in the liquidity trap: Further evidence

Quantitative easing (QE) ineffectiveness in periods of liquidity trap conditions has been empirically verified for Japan, USA, and the Eurozone, on the basis of a switching regimes approach. In this work, we present further evidence that unconventional monetary policies are impotent when policy rates are close to their lower bound, using monthly data from Sweden, Switzerland, and the UK, whose central banks also pursued QE policies in the aftermath of the 2008 financial crisis. For all the economies considered, we obtain evidence of drastic regime shifts for base money growth which are successfully captured by a Markov switching regimes representation, but inflation, investment expenditure growth, and broad money growth do not appear to change significantly in different QE policy regimes, thus pointing to unconventional monetary policy impotence.

Brazil and the Liquidity Trap

With high-interest rates being the norm as this is written, Brazil has little reason to be worried about liquidity traps which have recently resurged in international economic literature. Studies intertwining the Brazilian scenario with them have been sparse. However, Brazil's legislative framework raises alarms: fiscal legislation with the principle of legality as applied in the Brazilian scenario seems to form a problematic situation. The goal of this work is to alert one to the possible undesirable effects, caused by short-sighted legislation should a liquidity trap occur in Brazil, although it does not seem to be a concern in the short term. The methodology we use is descriptive and bibliographical, through a revision of the literature. We conclude that if the argument of a significant part of the literature is thought to follow, the country may find itself in a worrisome scenario.