Ask a Scholar: Low Interest Rates and the Liquidity Trap

John Mathys

Dear Ask a Scholar,

My question is about the state of the economy. More accurately it’s about the so-called "liquidity trap" that we might be falling in. What I really want to know is that the final equilibrium in the economy is presented by the IS, LM [Investment Saving/Liquidity preference Money] curve. Government spending shifts the LM curve thus decreases the interest rate.

So here is the question. Is there a point to have the government increase spending when the interest rate is already .25%?  Since the interest rate is so low will that cause us to be caught in a "liquidity trap" and does that effect really exist?

- Dmitriy Aronov, The City College of New York

Answered by John Mathys, Professor of Finance Emeritus at DePaul University. Dr. Mathys received his M.B.A. and his Ph.D. in finance from the Illinois Institute of Technology.

When talking about the "liquidity trap" we must look at the real interest rate [the interest rate adjusted for price changes up and down, that is, inflation and deflation] and to make  the analysis more complicated we must consider the effects of expected prices versus actual prices. If we do that the "liquidity trap" does not exsist. IS-LM curves are not suited to this analysis.

The U.S. Depression of the 1930's was thought to be an example of the weakness of monetary policy to affect the economy but Friedman and Schwartz proved that analysis wrong in A Monetary History of the United States 1867-1960, especially Chap .7 , "The Great Contraction" and Chap. 8 and 9. Monetary policy of the 1930's was analysed and a "liquidity trap" could not be found. If the "liquidity trap" did not exsist in the Depression, where would it exsist?

Perhaps in the fevered mind of a Keynesian.

* * *   

About “Ask a Scholar”

Have a question Wikipedia can’t answer? We’ll match your question to a scholar with an answer.  Questions submitted to “Ask a Scholar” should call for educated judgment rather than facts that can be found easily with an internet search. We especially welcome questions that provide professors the occasion to draw erudite distinctions and incorporate mention of matters you had no idea were connected to the topic at hand. Simply email NAS or submit questions via Intellectual Takeout's Ask the Professor feature. We'll field your question to a scholar and get back to you with an answer as soon as possible.

  • Share

Most Commented

November 24, 2021

1.

1619 Again: Revisiting the Project's Troubled Past

New York Times editor Jake Silverstein's new essay on the 1619 Project attempts to glide past the awkwardness that accompanied the project’s early days. Let's set the reco......

December 14, 2021

2.

Confronting Woke Groupthink in Art Education

The dubious notion that the U.S. is a “systemically racist” nation has taken hold in art education, as in virtually every sphere of American life....

January 18, 2022

3.

The White House Is Undermining Science, Not Defending It

Government support of scientific research is not designed to support science, but to harness science to political ends....

Most Read

January 18, 2022

1.

The White House Is Undermining Science, Not Defending It

Government support of scientific research is not designed to support science, but to harness science to political ends....

September 21, 2010

2.

Ask a Scholar: What Does YHWH Elohim Mean?

A reader asks, "If Elohim refers to multiple 'gods,' then Yhwh Elohim really means Lord of Gods...the one of many, right?" A Hebrew expert answers....

January 12, 2022

3.

Press Release: NAS Appoints Dr. J. Scott Turner as Director of the Diversity in the Sciences Project

As project director, Dr. Turner will be conducting research on the scope and deleterious effects of DEI initiatives in STEM programs across the country....