What is the free-market solution to a liquidity trap? Higher inflation!

Three seventeen-year old quotes from Paul Krugman (Paul R. Krugman (1998): It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap, Brookings Papers on Economic Activity 1998:2 (Fall), pp. 137-205):

Suppose that the required real rate of interest is negative; then the economy ‘needs’ inflation, and an attempt by the central bank to achieve price stability will lead to a zero nominal interest rate and excess cash holdings…


In a flexible-price economy, the necessity of a negative real interest rate [for equilibrium] does not cause unemployment…. The economy deflates now in order to provide inflation later…. This fall in the price level occurs regardless of the current money supply, because any excess money will simply be hoarded, rather than added to spending…. The central bank- which finds itself presiding over inflation no matter what it does, [but] this [flexible-price version of the liquidity] trap has no adverse real consequences…


A liquidity trap economy is “naturally” an economy with inflation; if prices were completely flexible, it would get that inflation regardless of monetary policy, so a deliberately inflationary policy is remedying a distortion rather than creating one…

Thinking about these three quotes has led me to change my rules for reading Paul Krugman.

My rules were, as you remember:

  1. Paul Krugman is right.
  2. If you think Paul Krugman is wrong, refer to (1).

They are now:

  1. Paul Krugman is right.
  2. If you think Paul Krugman is wrong, refer to (1).
  3. And even if you thought Paul Krugman was right already, go reread and study him more diligently–for he is right at a deeper and subtler level than you would think possible.

Let us imagine a fully-flexible distortion-free free-market economy–the utopia of the Randites. Let us consider how it would respond should people suddenly become more pessimistic about the future.

People feel poorer. Feeling poorer, people want to spend less now. However, today’s productive capacity has not fallen. Thus the market economy, in order to incentivize people to keep spending now at a rate high enough to maintain full employment, drops the real interest rate. It thus makes the future more expensive relative to the present, and makes it sufficiently more expensive to incentivize keeping real spending now high enough to maintain full employment.

The real interest rate has two parts. It is equal to:

  1. the nominal interest rate,
  2. minus the inflation rate.

If money demand in the economy is interest elastic, the fall in the real interest rate will take the form of adjustments in both pieces. First, the free-market flexible-price distortion-free economy’s equilibrium will shift to drop the nominal interest rate. Second, the equilibrium will also shift to drop price level will drop immediately and instantaneously. Then the subsequent rebound of the price level back to normal produces the inflation that is the other part of The adjustment of the real interest rate.

If money demand takes the peculiar form of a cash-in-advance constraint, then:

  1. the interest elasticity of money demand is zero as long as the interest-rate is positive, and then
  2. the interest elasticity of money demand is infinite when the interest-rate hits zero.

In this case, the process of adjustment of the real interest rate in response to bad news about the future has two stages. In the first stage, 100% of the fall in the real interest rate is carried by a fall in the nominal interest rate, as the price level stays put because the velocity of money remains constant at the maximum technologically-determined rate allowed by the cash-in-advance constraint. In the second stage, once the nominal interest rate hits zero, and there is no longer any market incentive to spend cash keeping velocity up, 100% of the remaining burden of adjustment rests on the expected rebound inflation produced by an immediate and instantaneous fall in the price level. These two stages together carry the real interest rate down to where it needs to be, in order to incentivize the right amount of spending to preserve full employment.

The free-market solution to the problem created by an outbreak of pessimism about the future is thus to drop the nominal interest rate and then, if that does not solve the problem, to generate enough inflation in order to solve the problem.

Now we do not have the free-market distortion-free flexible-price economy that is the utopia of the Randites. We have an economy with frictions and distortions, in which the job of the central bank is to get price signals governing behavior to values as close as possible to those that the free-market distortion-free flexible-price economy that is the utopia of the Randites would produce.

In particular, our economy has sticky prices in the short run. There can be no instantaneous drop in the price level to generate expectations of an actual rebound inflation. If the central bank confines its policies to simply reducing the nominal interest rate while attempting to hold its inflation target constant, it may fail to maintain full employment. Even with the nominal interest rate at zero, the fact that the price level is sticky in the short-run may mean that the real interest rate is still too high: there may still be insufficient incentive to get spending to the level needed to preserve full employment.

A confident central bank, however, would understand that its task is to compensate for the macroeconomic distortions and mimic the free-market flexible-price full-employment equilibrium outcome. It would understand that proper policy is to set out a path for the money stock and for the future price level that produces the decline in the real interest rates that the flexible-price market economy would have generated automatically.

Thus a confident central bank would view generating higher inflation in a liquidity trap not as imposing an extra distortion on the economy, but repairing one. The free-market flexible-price distortion-free economy of Randite utopia would generate inflation in a liquidity trap in order to maintain full employment–via this instantaneous and immediate initial drop in the price level. A central bank in a sticky price economy cannot generate this initial price-level drop. But it can do second-best by generating the inflation.

All of my points above are implicit–well, actually, more than implicit: they are explicit, albeit compressed–in Paul Krugman’s original 1998 liquidity trap paper.

And yet I did not come to full consciousness that they were explicit until I had, somewhat painfully, rethought them myself, and then picked up on them when I reread Krugman (1998).

On the one hand, I should not feel too bad: very few other economists have realized these points.

On the other hand, I should feel even worse: as best as I can determine, no North Atlantic central bankers have recognized these points laid out in Paul Krugman’s original 1998 liquidity trap paper.

Central bankers, instead, have regarded and do regard exceeding the previously-expected level of inflation as a policy defeat. No central bankers recognize it as a key piece of mimicking the free-market full-employment equilibrium response to a liquidity trap. None see it as an essential part of their performing the adjustment of intertemporal prices to equilibrium values that their flexible-price benchmark economy would automatically perform, and that they are supposed to undertake in making Say’s Law true in practice.

But why has this lesson not been absorbed by policymakers? It’s not as though Krugman (1998) is unknown, or rarely read, is it?

It amazes me how much of today’s macroeconomic debate is laid out explicitly–in compressed form, but explicitly–in Krugman’s (1998) paper and in the comments by Dominguez and Rogoff, especially Rogoff…

November 21, 2015


Brad DeLong
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