From zero to one, then back to zero: Economists’ evolving understanding of the zero-rate liquidity trap

Posted: December 31, 2015 in economy
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MY COLUMN this week sets out three possible scenarios for the American economy in 2016, in the aftermath of the Fed's first rate hike in more than nine years. Each scenario corresponds to an understanding of why it is that near-zero interest rates are so difficult to leave behind; economies eventually managed the trick in the decades after the Depression, but those that have sunk to the zero lower bound in recent years have been unable to escape it for long. 

What strikes me as interesting, and what motivated the column, is that our understanding of the pull of near-zero rates has evolved since late 2008, and continues to evolve, in a very ominous direction.Back in late 2008 and early 2009, when rates around the rich world fell below 1%, the framework most economists reached for was what you might call the traditional Hicks-Krugman story of the liquidity trap. John Hicks's analysis of the work of John Maynard Keynes first set out the concept of a liquidity trap in 1937. Paul Krugman borrowed and updated that framework in 1998 in an analysis of the Japanese economy. This story is one in which a really nasty economic shock knocks an economy into a bad equilibrium; rates fall to zero, at which point monetary policy loses its punch. Real rates can't go low enough to stimulate the economy, which remains stuck with a shortfall in demand. …

via Economic Crisis


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