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

January 24, 2024

1.

After Claudine

The idea has caught on that the radical left overplayed its hand in DEI and is now vulnerable to those of us who seek major reforms. This is not, however, the first time that the a......

February 13, 2024

2.

The Great Academic Divorce with China

All signs show that American education is beginning a long and painful divorce with the People’s Republic of China. But will academia go through with it?...

October 31, 2023

3.

University of Washington Violated Non-Discrimination Policy, Internal Report Finds

A faculty hiring committee at the University of Washington “inappropriately considered candidates’ races when determining the order of offers,” provided “disparate op......

Most Read

May 15, 2015

1.

Where Did We Get the Idea That Only White People Can Be Racist?

A look at the double standard that has arisen regarding racism, illustrated recently by the reaction to a black professor's biased comments on Twitter....

October 12, 2010

2.

Ask a Scholar: What is the True Definition of Latino?

What does it mean to be Latino? Are only Latin American people Latino, or does the term apply to anyone whose language derived from Latin?...

July 8, 2011

3.

Ask a Scholar: What Is Structural-Functionalism, Conflict Theory and Symbolic Interactionism?

Professor Jonathan Imber clarifies concepts of sociologocal theory....