Keynes on How to Create a Liquidity Trap

March 10, 2009

by Mario Rizzo

 

There is frequently confusion about whether John Maynard Keynes thought monetary policy is effective. This confusion is furthered by some renditions of John Hicks’s graphical IS-LM analysis (which, by the way, he repudiated in the 1980s). Most economics undergraduates have been subjected to this art.

 

The simple story about Keynes’s view is that he thought that the Bank of England should keep long-run interest rates low. This would be effective in maintaining high employment over long periods of time.  But short run, countercyclical monetary policy is another matter.

 

Economists are familiar with the Keynesian liquidity trap. This is the idea that the demand to hold money, rather than invest it, is so high at very low rates of interest that further lowering does no good. In other words, monetary policy cannot induce more investment even at lower rates. One reason proffered for this is that when entrepreneurial expectations are very pessimistic the interest rate is the least of a potential investor’s concerns. He does not expect a positive net return even at near-zero interest rates.

 

This was not Keynes’s principal argument, according to Allan Meltzer (with whom I concur). Keynes’s argument in “How to Avoid a Slump” is that “[v]ariability of interest rates creates uncertainty and inhibits investment” (Meltzer, Keynes’s Monetary Theory: A Different Interpretation, p. 195).

 

As Keynes says:

 

“A low enough long-term rate of interest cannot be achieved if we allow it to be believed that better terms will be obtainable from time to time by those who keep their resources liquid. The long-term rate of interest must be kept continuously as near as possible to what we believe to be the long-term optimum. It is not suitable to be used as a short-period weapon.” (“How to Avoid a Slump,” The Times, Jan. 13, 1937, p.13).

 

A deceptively similar argument is that at low short-term interest rates people believe there is nowhere to go but up. So they are reluctant to hold bonds because they fear capital losses if they are caught holding bonds when the rates rise. This argument assumes that the deviation between the actual rate and the expected rate is simply a function of the certain level of actual rates.

The nuance here is that short-run monetary policy can create a liquidity trap. Suppose potential bond purchasers know that a discretionary policy is in place such that the central bank will continually manipulate rates, up or down, as it believes inflation or recession are threatened. Then when interest rates are low during recessions they will know that this is not permanent but that they will rise later. Of course, they will not know precisely when or by how much.

As Keynes says in the General Theory “what matters is not the absolute level of r [interest rate] but the degree of its divergence from what it considered a fairly safe level of r…” (p.202). It is the safety or certainty of the long-rate that is at issue. If people believe a countercyclical policy is operative, then their expectations of a fairly safe level will be unsettled. They will be uncertain about what to expect. So they may not hold bonds because they fear capital losses.  

 

What is particularly interesting to me about this is that illustrates once again that policy regularity and predictability – in this case permanently low long-term interest rates – are key to Keynes’s mature analysis of the macroeconomy. Discretionary countercyclical monetary policy can be ineffective, not because it is monetary policy, but because it generates uncertainty.

 

 

8 Responses to “Keynes on How to Create a Liquidity Trap”


  1. The so-called “critical interest rate,” which can differ from person to person but, in the aggregate, is said to create a convex speculative demand for money curve.

  2. john pertz Says:

    professor rizzo can you please post more often. Between yourself and alex t over at marginal revolution I learn more economics than anywhere in the blogosphere. I’ve read krugman on the liquidity trap problem a million times and he is never as lucid and comprehensive as you were in your explanation.

    Thank you.


  3. I’ve been arguing just the point that fluctuating interest rates create both uncertainty and boom-bust cycles. Thanks for the reference.

  4. knapp Says:

    Are you saying that the mature Keynes was a Post Keynesian? or at least Post Keynesian-ish?

  5. Joe Calhoun Says:

    Just another argument for a stable dollar if you ask me. It is the volatility that causes the problems. In a stable dollar environment the volatility of interest rates and commodities are both much lower than in a fiat world.

  6. Danny Shahar Says:

    I’m not sure if this post had anything to do with this, but in any case, thank you! This was great!

  7. Andrew Says:

    Stabilization of the investment environment was one of the keys to Keynes thinking. This included or might be said to include;

    * Low and highly stable interest rates
    * Approximately balanced budgets (actually two; a capital account for investment expenditures and a ‘current’ account for regular spending)
    * Stable and/or predictable regulatory environment
    * Fixed exchange rates
    * Commodity price stabilization schemes
    * Stable taxation rates and types
    * Industrial policy that rules out nationalization

    Any of these would, or might reduce investment uncertainty, and so by doing increase the ‘Marginal Efficiency of Capital’, resulting in greater effective demand, output and employment.

    Unfortunately, stabilization thinking does not really figure in modern macroeconomic thinking, at least not at the into/intermediate text level.

  8. Drewfuss Says:

    “As Keynes says in the General Theory “what matters is not the absolute level of r [interest rate] but the degree of its divergence from what it considered a fairly safe level of r…””

    What does Keynes mean by ‘safe’ in this context? Is it in regard to inflation?


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