The recent FOMC statement by the Federal Reserve (Fed) included the line that “… the probability of **an unwelcome substantial fall in inflation**, though minor, exceeds that of a pickup in inflation from its already low level” (emphasis added.)

It occurred to me that this statement might be a little confusing – isn’t inflation supposed to be bad? Why would a fall in inflation be “unwelcome”?

The answer has to do with what economists call a “liquidity trap.” (Note: the full analysis of a liquidity trap is considerably more complicated than below, but this should convey the basic idea.)

**Liquidity Trap**

The basic argument is that the interest elasticity of money demand increases, and monetary policy becomes less effective, when the nominal interest rate approaches zero.

Ok, here’s the English version.

The way the Fed lowers interest rates is to expand the money supply by buying bonds from the public – in this way money moves from the Fed’s vaults to people’s pockets.

Suppose that the Fed wants to lower interest rates, say because there is a recession. Normally, people have to be enticed to give up their bonds because they pay interest. So, to increase the money supply, the Fed must offer people a higher price for the bonds the public owns – thus lowering the interest rate for new borrowers (all in order to make bonds less attractive for the public to hold.)

In a liquidity trap, however, people are willing to part easily with their bonds, since they pay little or no interest and are hence roughly equivalent to holding cash; and so only a very small change in price is needed to buy the bonds – even if the Fed is buying lots of them. As a result, there will be very little change in interest rates. In the extreme, the Fed may not be able to have any significant impact on interest rates, and hence may not be able to help stimulate the economy.

In short, the economy will be in a liquidity trap if/when the Federal Reserve cannot boost the economy because they have lowered interest rates as much as they can.

The liquidity trap is more than just a theoretical possibility; some have suggested that this may be what happened in Japan in the mid 1990’s (although there are different views on the topic). In any case, they still haven’t fully recovered.

There are, of course, opponents of the idea that a liquidity trap can really be important. An easy fix would seem to be to rapidly expand the money supply to generate inflationary expectations and hence drive the economy easily out of the so-called trap.

The open question is whether the US is in, or near, a liquidity trap. Paul Krugman has some textbook econ 101 (IS/LM AS/AD) analysis of the current economic situation and the possibility of a liquidity trap. He has a more detailed analysis… and with graphs too! See below.

**Real Interest Rates**

A second problem arises because the Fed can’t lower (nominal) rates below zero (try this thought experiment: how much money would you borrow if interest rates were -10%?). However, the Fed can lower real rates below zero *provided there is some inflation*.

If there is some inflation, then the “real” rate of interest can be less than zero. Think of the real rate of inflation as what determines the purchasing power of the money you would need to repay on a loan, rather than the numerical value. The nominal rate is simply the interest rate you see reported in the newspaper. So if there is some inflation, the real rate will be less than the nominal rate, since inflation will erode some of the purchasing power of the money you have to repay. It is this real rate of return that businesses and consumers really care about – not the nominal rate.

The relation between real and nominal rates is given by the equation, well approximation, real = nominal – inflation. Now, if the nominal rate is bounded by zero, then we know that the real rate is bounded by the negative of the inflation rate. So, when the inflation rate gets near zero, we have a greater lower bound on the real interest rate.

(Ok, I’ve glossed over the expected component of inflation in the above two paragraphs, but you get the idea.)

In other words, the Fed has less room to maneuver when inflation is exceptionally low. With very low interest rates and very low inflation, the Fed, therefore, will not be able to help get the economy moving again, simply because there is no room left to lower real rates.

**More**

For more see…

Elephant [poop] (5/5/03)

Zero is not enough (5/4/03)

Even more about jobs (4/29/03)

Fiscal policy and employment (4/28/03)

For a more detailed treatment in a more complicated intertemporal model see Thinking about the Liquidity Trap.

For a nice overview and ways to escape the trap see Svensson’s Escaping from a Liquidity trap and Deflation: The Foolproof Way and Others

Filed under: Economics, Economy, Fiscal Policy, Monetary Policy, Policy, Recession