Matt Rognlie takes to task Tyler Cowen for claiming there is no liquidity trap. He makes his case for the liquidity trap and then closes with this statement:
This doesn’t mean that all hope is lost: the Fed can still make a difference by shaping expectations of the future trajectory of nominal interest rates, or by making unconventional bond purchases so large that they trigger portfolio balance effects and drive down interest rates on longer-maturity assets...Just don’t go around claiming that 0% isn’t a barrier—because sadly, it is.
Ironically, the above bold phrase is exactly why in most circumstances there is no liquidity trap at the 0% barrier. To see this, first recall that a liquidity trap is a situation in which the demand for money is perfectly elastic. That is, no matter what the central bank does it cannot cause money demand to budge. Monetary policy, therefore, is unable to address the problems created from excess money demand in a liquidity trap.
Now Rognlie claims this happens once the central bank's targeted short-term interest rate hits the 0% barrier. This assumes that money demand is only affected by the targeted short-term interest rate. Milton Friedman argued, however, that money demand is affected by a spectrum of interest rates and that there is still much the Fed can do when the short term interest rate hits 0%. The Fed can still go after long-term treasury yields and corporate bond yields which Friedman believed were also important determinants of money demand. If so, money demand can still be influenced by the Fed and thus there is no liquidity trap.
The portfolio balance channel mentioned by Rognlie above is implicitly making this very point. In that channel, the Fed through its purchases of longer-term securities can drive down longer-term yields. This causes a rebalancing of portfolios that will lead to purchases of normally riskier assets like stocks and capital. These developments imply a decline in money demand. Thus, to claim there is a portfolio balance channel is to claim that there is no liquidity trap at the 0% bound of the short-term interest rate. Rognlie's endorsement of the portfolio balance channel, then, implies Tyler Cowen's skepticism of the liquidity trap is well founded.
So is there any evidence that money demand can be influenced by a spectrum of interest rates? Some older studies do show this, but for now here are three figures that suggest that answer is yes. They all show MZM velocity (i.e. GDP/MZM) to be systematically related to various interest rates. (The R2 for these relationships is always above 70%.)
In general, the 0% bound on short-term interest rates is not a sufficient condition for a liquidity trap. It requires individuals to become satiated with money balances which implies there must be deflation. Even then, Peter Ireland has shown using the Krugman liquidity trap model that if there is population growth then there will be distributional effects of money growth that will eliminate the liquidity trap.
Currently, we are far from a liquidity trap though money demand remains elevated and a drag on the economy. That being the case, there is much that monetary policy could do to address the excess money demand problem and get nominal spending going again. Here is one suggestion.
Update: See Josh Hendrickson's reply.
Update II: See Scott Sumner's earlier comments on the liquidity trap.
The portfolio balance channel mentioned by Rognlie above is implicitly making this very point. In that channel, the Fed through its purchases of longer-term securities can drive down longer-term yields. This causes a rebalancing of portfolios that will lead to purchases of normally riskier assets like stocks and capital. These developments imply a decline in money demand. Thus, to claim there is a portfolio balance channel is to claim that there is no liquidity trap at the 0% bound of the short-term interest rate. Rognlie's endorsement of the portfolio balance channel, then, implies Tyler Cowen's skepticism of the liquidity trap is well founded.
So is there any evidence that money demand can be influenced by a spectrum of interest rates? Some older studies do show this, but for now here are three figures that suggest that answer is yes. They all show MZM velocity (i.e. GDP/MZM) to be systematically related to various interest rates. (The R2 for these relationships is always above 70%.)
In general, the 0% bound on short-term interest rates is not a sufficient condition for a liquidity trap. It requires individuals to become satiated with money balances which implies there must be deflation. Even then, Peter Ireland has shown using the Krugman liquidity trap model that if there is population growth then there will be distributional effects of money growth that will eliminate the liquidity trap.
Currently, we are far from a liquidity trap though money demand remains elevated and a drag on the economy. That being the case, there is much that monetary policy could do to address the excess money demand problem and get nominal spending going again. Here is one suggestion.
Update: See Josh Hendrickson's reply.
Update II: See Scott Sumner's earlier comments on the liquidity trap.
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