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.

* * *   

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