public-policy, monetary-policyWhat is the optimal monetary and fiscal policy response for a country that has the following characteristics:
Assume the country has a free floating exchange, fiat money, and fractional reserve banking.
It really depends on what your model says it’s the cause of the liquidity trap. Let me provide three simple examples
Liquidity trap is a situation when the LM curve is flat. Changes in money supply have no effect on interest rates and interest rates are not low enough (even at 0) to get full employment. Basically AD-AS curves are parallel and never meet.
In this world the solution is government spending. With flat LM the IS curve can be very effective and restore traction to the economy.
Reference:
Heijdra, Foundations of Modern Macroeconomics. It is a senior/master level book and the most comprehensive approach to IS-LM. I know of no doctorate level book on the subject. I think IS-LM is “obsolete” there.
You can get out of liquidity trap by managing expectations.
To maximize utility you have to solve a consumption Euler equation. This Euler equation is why interest rates stimulate the economy.
While old-Keynesian thinking focuses only on short-term interest rates, the Euler equation contains also “expected” long term rates.
Even though short interest rates are 0 in a liquidity trap, you can still get away by changing consumer expectations of what future interest rates will be. Whether you actually can do it is debatable, but things like nominal GDP targeting and Operation Twist can be explained with this
Reference:
Palgrave Dictionary of Economics, The Liquidity Trap. That goes straight to the point. To really know more you need a full advanced macroeconomics curriculum.
Liquidity trap and deflation are a consequence of asset prices collapse. Managing them is useless, the only solution is fixing private balance sheets.
Firms have positive cash flow but are technically bankrupt as the assets have lost value while liabilities have stayed equal. All firms and consumers do is to accumulate cash until they are no more “bankrupt”.
You can only help them clean their balance sheet to speed up recovery.
Reference:
Richard Koo, The Holy Grail of Economics. A bit high sounding, but interesting.
There are, historically, four ways out of a trap like this, where demand has been suppressed by private-sector deleveraging - the “debt hangover”
1) Erode that debt by initiating a period of currency devaluation and inflation. Nominal earnings will rise, reducing the debt:income ratio, until demand is stimulated again. Bear in mind that it is difficult to do this if several of your trading partners are trying to do the same thing (the currency devaluation, and thus inflation on imported goods, will fail).
2) Go through a long period of deflation, grinding down the population’s expectations and aspirations; then have a war to force a government to invest directly and hugely in industrial expansion for the war effort.
3) Engage in a large-scale expansion of public debt, running a much larger fiscal deficit, with the public sector investing directly in wealth-generating assets, into any assets that give a return of at least the rate of borrowing. There is a risk here that the trade deficit will result in demand for imports rising significantly; thus domestic demand will be stimulated, but domestic supply will not.
4) Have a debt-jubilee: go through a phase of cancellation of private debt, while providing government backing to recapitalise the balance sheets of any private-sector financial institutions that would otherwise collapse due to the cancellation; do this recapitalisation in exchange for bank equity, and for corporate holders of bank-bonds taking a haircut on the bonds.
A good policy response would be export promotion. That would lessen the foreign exchange gap. Greater aggregate demand would also lift inflation (and interest rates), while increasing employment. Samuelson opined that even if “export promotion” meant dumping product into the sea, it would still be a good idea, because the various “multiplier” effects would offset the lost output.
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