Escaping from Liquidity Trapt

8/11/2019 Escaping from Liquidity Trapt

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Escaping from Liquidity TrapEscaping from Liquidity Trap

ECO431ECO431

Submitted bySubmitted by

Obedur Rashid Bin Sarat !aderiObedur Rashid Bin Sarat !aderi

"31"#""$"31"#""$

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%bstract%bstract

&n internationa' finance (or'd is facing great prob'ems in fi)ing the e)change rate for 'iquidity

trap* & (ou'd 'ie to go through ho( it can be possib'e to fi) the e)change rate to escape from the

'iquidity trap in this paper* & got he'p from different boos* & a'so 'ooed for some artic'e in the

(eb and & used that information in this paper* & attached name of those boos and artic'es in the

bib'iography* +ere & pro,ided some thought about e)change rate first and then started about

'iquidity trapped and conc'uded to suggest that countries (hich are under the 'iquidity trap

shou'd fo''o( the recommended methods* This is a ,ery ,ast topic- but & tried to gi,e concise

information*

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Tab'e of ContentsTab'e of Contents

&ntroduction**************************************************************************************************************************************4

Escaping from the Liquidity Trap****************************************************************************************************#

Eccentric .onetary /o'icy**************************************************************************************************************#

% Ta) on .oney******************************************************************************************************************************0

E)pansionary isca' /o'icy**************************************************************************************************************2

Lo(er the ero omina' &nterest Rate Le,e'**********************************************************************************5

6arious .ode's7 8sed in to Escape the Liquidity Trap*******************************************************************9

Conc'usion*************************************************************************************************************************************1"

Bib'iography**********************************************************************************************************************************11

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Introduction

&n internationa' finance system (or'd is facing great prob'ems in fi)ing the e)change rate for

'iquidity trap* &n this paper & (ou'd 'ie to go through- ho( can it be possib'e to fi) the e)change

rate to escape from the 'iquidity trap*

Liquidity traps occur (hen the economy sti'' has insufficient aggregate demand e,en (hen the

:ero nomina' interest bound becomes binding* &t is a standard ,ie( that ;apan has a'ready been

trapped* .uch research has been accomp'ished to e)amine the propositions of 'o( interest rates

and def'ation moti,ated by both po'icy and academic interests* Basica''y pre,ent and cure of

'iquidity traps* <Buiter <$""3=> C'ouse et a'* <$""3=> 8''ersma <$""$= for re'e,ant 'iterature

re,ie(s=

%s (e no(- money is the most 'iquid of assets* That can be e)changed for goods (ithout

difficu'ties* The nomina' interest rate strie :eroes in the 8nited States during the e)tended great

depression of the 193"?s- and that (as ca''ed a 'iquidity trap* The centra' ban cannot reduce it

further by increasing the money supp'y* Economists thought 'iquidity traps (ere an obsession of

the past unti' ;apan actua''y fe'' into one in the 'ate 199"?s* E,en though a progressi,e 'o(ering

of interest rates by the ban of ;apan- the country?s economy has stagnated for o,er a decade*

The country?s short@term interest rates had effecti,e'y reached :ero by 1999* The Ban of ;apan

reported that une)pected interest rate became on'y "*""4 percent in o,ember $""1*

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Ahen the :ero bound is binding- monetary po'icy (i'' become ineffecti,e and fisca' po'icy needs

to p'ay a maor ro'e in pu''ing the economy out of 'iquidity traps according to fi)ed &S@L.

perspecti,e* .any economists point out that monetary po'icy can sti'' p'ay a maor ro'e in fi)ing

'iquidity traps* The binding :ero bound maes it impossib'e to further reduce the short@term

nomina' interest rate* The centra' ban can inspire aggregate demand through uncon,entiona'

monetary po'icy* %nother popu'ar notion is that inf'ation e)pectations can be managed to reduce

the ris of a binding :ero nomina' interest bound- and 'o(er the rea' interest rate (hen the bound

becomes binding* &n addition- the e)change rate has been suggested as an imp'ement to re'ease

the economy from 'iquidity traps*

Escaping from the Liquidity Trap

&n a 'iquidity trap- there are some (ays to escape@

1* Eccentric monetary po'icy

$* % Ta) on .oney

3* E)pansionary fisca' po'icy*

4* Lo(er the :ero nomina' interest rate 'e,e'

Eccentric Monetary Policy

%ccording to monetary po'icy- 'ong@term interest rates ha,e room to fa''* %ccurate'y designed

uncon,entiona' monetary po'icies (i'' a''o( the centra' ban to stimu'ate aggregate demand

through reducing 'ong@rates* +o(e,er- if the natura' 'ong@term nomina' interest rate becomes

negati,e- these uncon,entiona' po'icies (i'' become po(er'ess as (e''*

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Ahen the short end of yie'd cur,es is touching on the ground :ero- the 'ong end can sti'' ha,e

some room to fa''* Therefore- the short@term interest rate running out of ammunition- the centra'

ban sti'' has se,era' uncon,entiona' methods to reduce the 'ong@term interest rate* Ahen the

:ero bound is binding- monetary e)pansion through open maret purchases cannot further reduce

the short@term interest rate- but mere'y increase the quantity of money he'd by the pri,ate sector*

%s money and short@term go,ernment bonds become perfect substitutes at a binding :ero bound-

the portfo'io@ba'ance impact of a change in the ratio bet(een them may not be significant* The

centra' ban can a'so inf'uence 'ong@term interest rates ,ia direct'y purchasing 'ong@term

go,ernment securities- or e,en pri,ate@sector assets such as stocs and rea' estate <C'ouse et a'*

$""3> oodfriend $"""> .e't:er $""1=* % do(nside of this method is its tendency to increase the

centra' ban?s direct in,o',ements in financia' business and hence comp'icate monetary po'icy

imp'ementation* or e)amp'e- the 'oading and un'oading of pri,ate@sector assets on the centra'

ban?s ba'ance sheet (i'' 'ie'y in,o',e many go,ernance issues <Buiter- $""3=* &n some (ay- the

centra' ban can inf'uence 'ong@term interest rates through a commitment to a 'asting- 'o(@

interest po'icy- such as the :ero@interest po'icy adopted by Ban of ;apan in $""1* &f credib'e-

this po'icy (i'' he'p to reduce 'ong@term interest rates* On the other hand it can remain at a

re'ati,e'y high 'e,e' due to ris or other premiums* Thus- it can be fi)ed the e)change rate to

escape from the 'iquidity trap*

A Tax on Money

&t can be another (ay of escape from the 'iquidity trap to e'iminate the :ero bound on nomina'

interest rates by introducing a ta) on money <oodfriend <$""$= and Buiter and /anigirt:og'ou

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<1999==* Such as- ta) (ou'd permit negati,e nomina' interest rates in equi'ibrium- and a''o( the

centra' ban to accomp'ish its most (anted stimu'ating negati,e interest rate* &t is strict'y sufficient to

introduce a ta) on commercia'@ban reser,es in the centra' ban and on e'ectronic money* or the

e)amp'e- it can be consumer cash cards* Con,erse'y- introducing a ta) on currency requires technica'

impro,ements 'ie e'ectronic chips in the notes or a 'ottery that determines (hat numbered notes in a

series become (orth'ess in each period* &t cou'd a'so imp'y the incon,enience of notes circu'ating

(ith the same denomination- but trading at different discounts* One might a'so e)pect some pub'ic

bitterness beside a system that (ou'd mae some of the money in peop'e?s pocets conspicuous'y

(orth'ess*

Expansionary Fiscal Policy

isca' po'icy is an apparent course of action substitute in 'iquidity trap (hen the traditiona' monetary

po'icy is inadequate* Sti''- the efficiency of this po'icy depends to an e)tensi,e 'e,e' on the feedbac

of the concea'ed region* &f the initia' 'e,e' of go,ernment 'iabi'ity is high and a higher 'iabi'ity is

considered f'a(ed- a po'icy of higher go,ernment 'iabi'ity may cause the concea'ed region to e)pect

ta) increases or go,ernment benefit reduction in the near future* % resu'ting increase in concea'ed

region sa,ing (i'' then reduce any shoc of the e)pansionary fisca' po'icy*

Depending on the e)tent of autonomy of the centra' ban- the pri,ate sector might a'so anticipate that

increased budget deficits (i'' be financed by the centra' ban* .ost probab'y this can be going ahead

to inf'ation e)pectations* Con,erse'y- e)pansionary fisca' po'icy o,er a number of years has 'ed to a

dramatic increase in ;apan- (here go,ernment 'iabi'ity- (ithout stimu'ating the economy out if its a

recession and 'iquidity trap* or ;apan- a further bond@financed fisca' e)pansion may be neither

successfu' nor estab'ished by 'enders (ithout significant interest@rate increases- (hich (ou'd defeat

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the stimu'us* % money financed fisca' e)pansion is a budget deficit financed by the printing press- or

more precise'y- by the centra' ban buying the go,ernment bonds issued to finance the deficit may

sti'' be e)pansionary- since a money@financed fisca' e)pansion need not necessari'y be fo''o(ed by

e,entua' ta) increases or e)penditure cuts* % price@'e,e' target for ;apan is combined (ith a money

financed fisca' e)pansion* +o(e,er- the e)pansion of the money supp'y needs- e,en in this case not

be permanent and credib'e* .oreo,er- high inf'ation may induce the centra' ban to reduce the

money supp'y and increase the da::'ing go,ernment 'iabi'ity

Lower the Zero ominal Interest !ate Le"el

/eop'e (ou'd find money strict'y preferab'e to bonds at negati,e nomina' interest rates* %s a

resu't bonds (ou'd be in e)cess supp'y* %'though a :ero interest rate- possib'y (i'' satisfy

borro(ers- (ho can borro( for free* Consequent'y- it (orries macroeconomics po'icy maers-

(hom are trapped in a situation (here they may possib'y no 'onger be ab'e to turn the economy

from first to 'ast straight monetary e)pansion* +o(e,er a go,ernment can escape from a

'iquidity trap by fi)ing its currency e)change rate at a sufficient depreciated 'e,e'*

The di'emma a centra' ban faces (hen the economy is in a 'iquidity trap brae can be seen by

considering the interest parity condition (hen the domestic interest rate is@

R F " F RG H <Ee E= I E

or the moment assume that the e)pected future e)change rate- E e- is fi)ed* Suppose the centra'

ban raises the domestic money supp'y so as to depreciate the currency temporari'y* The interest

parity condition sho(s that E cannot rise once R F "- because the interest (ou'd ha,e to become

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+ere omina' interest is a'ready :ero* urther increase in money supp'y has no effect on the

interest rate* .onetary po'icy cannot affect it if the output is 'o(er than its natura' 'e,e'* Ae ha,e

a'ready seen the interest parity condition before*

&onclusion

1* &n this paper- (e ha,e seen that monetary po'icy is an ineffecti,e too'- (hereas fisca' po'icy is

an effecti,e one under the fi)ed e)change rate regime*

$* E'iminating the :ero bound on nomina' interest rates by introducing a ta) on money can be

another (ay to escape from this trap*

3* .onetary e)pansion has no effect on output- (here output is trapped*

4* The centra' ban has to peg the e)change rate at a 'e,e' higher than the e)pected future e)change

rate*

#* 8nder this condition (or'd demand for domestic goods rises and the currency depreciates*

The countries (hich are under the 'iquidity trap may adopt these p'ans to escape* But the

a'ternati,e is a 'ong period of def'ation that brings about equi,a'ent rea' currency depreciation-

for the reason that prob'ems appear to be as much po'itica' as economic* So it is hard to predict

ho( and (hen these countries (i'' escape from their 'iquidity traps*

'i(liography

1"



1. Brittan, Samuel J How to escape the liquidity trapK

8RL7 (((*samue'brittan*co*u > Aednesday- December 1- $""4

2. Daniel, Josep P. and !anoose, Da"id D. J International Monetary and Financial

EconomicsK7 Aednesday- December 1- $""4

#. $ru%man, Paul &. and '(st)eld, Maurice J International EconomicsK7 Aednesday-

December 1- $""4

*. $ru%man, Paul* J Japan’s TrapK

8RL7 (eb*mit*eduIrugmanI(((I'iquid*htm'> Aednesday- December 1- $""4

+. Jonsson, &icard B -The Liquidity7 Trap MythK8RL7 (((*mises*orgIfu''story*asp > Aednesday- December 1- $""4

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http://www.samuelbrittan.co.uk/


http://www.mises.org/fullstory.asp


http://www.mises.org/fullstory.asp

Escaping from Liquidity Trapt

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