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How close are we to a liquidity trap?
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Conventional monetary policy is ineffective in a liquidity trap. At that point short term interest rates are at zero, and conventional monetary policy is ineffective at this zero bound. Unconventional policies such as buying long term Treasury bonds by the Federal Reserve may be adopted, but their effectiveness has not been proven. This is something the Fed is attempting to do in the U.S. after the 2008 financial crisis. This was tried in Japan in a deflationary situation and the results did not show conclusively that it works, because Japan remained at a borderline deflationary situation for years while this policy was implemented by the Bank of Japan. The $600 billion bond buying program of the U.S. Fed in late 2010, known as QE II, was implemented to reduce the chance of deflation taking hold and to stimulate growth. Krugman and others argue for the need of fiscal policy and government spending to step in to support the unconventional monetary policy. This becomes more difficult to do with the increasing budget deficit the U.S. is facing in 2011.
Liquidity Trap in Japan and the U.S.
03/17/2008
With the demand curve for money horizontal further increases in the money supply do little to lower interest rates, or as in the current situation where the interest rates in the US are virtually at zero so that further increases in the money supply do little to stimulate the economy. As unemployment is growing and the financial sector weak, Bernanke and the Fed see other ways in which quantitative easing helps a recovery. Here Chritopher Woods compares today's situation in America to that of postbubble Japan. He says America is already in a liquidity trap. And the regulatory forbearance to cleanup the banking mess is similiar to that in postbubble Japan when it took the government years to get up the will and strength to straighten out the mess including breaking up the banks that are too big to fail.
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