…and start thinking strategically!
From Robert Hetzel:
To start, it is important to clear away the confusion surrounding the popular use of the term “liquidity trap” as a catchall phrase expressing the impotence of monetary policy. A liquidity trap is different from the zero-lower-bound problem, which expresses the fact that in a world of fiat money the nominal interest rate cannot fall below zero. The real interest rate (the nominal interest rate minus expected inflation) is the price that borrowers pay for transferring consumption from the future to the present. Alternatively, it is the price that lenders receive for deferring consumption from the present to the future. If individuals are sufficiently pessimistic about the future, the real interest rate could be negative. By itself, however, that fact is uninformative for policy without knowledge of the shock (monetary or real) that caused the pessimism.
The zero-lower-bound problem is different from a liquidity trap. The idea of a liquidity trap is that individuals will exchange assets with the central bank for money to an unlimited amount with no incentive to run down their increased money holdings through additional spending. As a result, the central bank loses its ability to influence the dollar expenditure of the public. Tim makes the monetarist argument that as long as the central bank buys illiquid assets, the public is left with a more liquid asset portfolio after the exchange. If the public was holding a balanced portfolio before, then it will try to run down its higher money holdings through bidding for other illiquid assets and, in the process, bid up their prices. Higher prices for illiquid assets like real estate and equities will make investment more attractive.
If the public is sufficiently pessimistic about the future so that asset prices are low and the demand for money is high, the central bank might have to create a significant amount of money to influence the expenditure of the public. The institutional fact that makes a liquidity trap an irrelevant academic construct is the unlimited ability of the central bank to create money. One can make this point in an irrefutable manner by noting that the logical conclusion to unlimited open-market purchases is that the central bank would end up with all the assets in the economy including interest-bearing government debt, and the public would hold nothing but non-interest-bearing money. Because that situation is untenable, individuals would work backward from that endpoint and begin to run down their money balances and stimulate expenditure in the current period.
What drives the conclusion that the central bank can control the dollar expenditure of the public is that the central bank can conduct monetary policy as a strategy, say, by altering the monetary base and the money stock by whatever amount necessary to maintain nominal expenditure on track. Historically, however, the FOMC has never been willing to communicate its behavior as a “policy” in the sense of systematic procedures designed to achieve an articulated, quantifiable objective (a reaction function). Instead, it communicates individual policy actions such as changes in the funds rate or, since December 2008, changes in the size and composition of its asset portfolio. Just as importantly, it explains those individual policy actions using the language of discretion.