Monday, May 13, 2013

The ZLB in My Favorite Textbook

In a recent blog post, Paul Krugman writes:
As far as I know, among basic textbooks only Krugman/Wells even talks about the liquidity trap.

This is probably a true statement.  It is not that other books don't cover the topic, however.  It is just that Paul Krugman doesn't know it.

FYI, here is what the leading introductory text says about the topic:

The Zero Lower Bound
As we have just seen, monetary policy works through interest rates. This conclusion raises a question: What if the Fed’s target interest rate has fallen as far as it can? In the recession of 2008 and 2009, the federal funds rate fell to about zero. What, if anything, can monetary policy do then to stimulate the economy?
Some economists describe this situation as a liquidity trap. According to the theory of liquidity preference, expansionary monetary policy works by reducing interest rates and stimulating investment spending. But if interest rates have already fallen almost to zero, then perhaps monetary policy is no longer effective. Nominal interest rates cannot fall below zero: Rather than making a loan at a negative nominal interest rate, a person would just hold cash. In this environment, expansionary monetary policy raises the supply of money, making the public’s asset portfolio more liquid, but because interest rates can't fall any further, the extra liquidity might not have any effect. Aggregate demand, production, and employment may be "trapped" at low levels.

Other economists are skeptical about the relevance of liquidity traps and believe that a central bank continues to have tools to expand the economy, even after its interest rate target hits its lower bound of zero. One possibility is that the central bank could raise inflation expectations by committing itself to future monetary expansion. Even if nominal interest rates cannot fall any further, higher expected inflation can lower real interest rates by making them negative, which would stimulate investment spending. 

A second possibility is that the central bank could conduct expansionary open-market operations with a larger variety of financial instruments than it normally uses. For example, it could buy mortgages and corporate debt and thereby lower the interest rates on these kinds of loans. The Federal Reserve actively pursued this last option during the downturn of 2008 and 2009.

Some economists have suggested that the possibility of hitting the zero lower bound for interest rates justifies setting the target rate of inflation well above zero. Under zero inflation, the real interest rate, like the nominal interest, can never fall below zero. But if the normal rate of inflation is, say, 4 percent, then the central bank can easily push the real interest rate to negative 4 percent by lowering the nominal interest rate toward zero. Thus, moderate inflation gives monetary policymakers more room to stimulate the economy when needed, reducing the risk of hitting up against the zero lower bound and having the economy fall into a liquidity trap.