Friday, May 6, 2011

Post Keynesians Reject the Liquidity Trap

As I have pointed out before, Keynesianism comes in 3 forms:
(1) Neoclassical synthesis Keynesians (= Old Keynesians);
(2) New Keynesians;
(3) Post Keynesians.
See “Neoclassical Synthesis Keynesianism, New Keynesianism and Post Keynesianism: A Review,” July 7, 2010.
Post Keynesian economics is what this blog advocates, and most people do not understand that Post Keynesianism rejects the neoclassical synthesis idea of the liquidity trap. In the original formulation of the concept, a liquidity trap is the existence of an infinitely elastic or a horizontal demand curve for money at some positive level of interest rates.

It should be noted that the expression “liquidity trap” is also used loosely or in a weak sense by New Keynesians like Krugman to mean that interest rates cannot fall below zero and that monetary policy can become impotent in some situations, which is perfectly true. That rather different definition of the “liquidity trap” is not objectionable. But it is the original neoclassical synthesis concept I am talking about here.

Keynes’ General Theory of Employment, Interest and Money (1936) gives us a theory of real world capitalist economies, where we have a monetary production economy, fundamental uncertainty, subjective expectations, contracts, inflexible or “sticky” wages, and money with a zero or very small elasticity of production, and money and financial assets with zero elasticity of substitution with producible commodities. But in fact Keynes did not regard the original liquidity trap idea as a real world phenomenon. Paul Davidson explains:
“…Old Keynesians claimed that, at some low, but positive, interest rate, the demand curve for speculative money balances become infinitely elastic (horizontal). This horizontal segment of the speculative demand curve was designated the liquidity trap by Old Keynesians such as Paul Samuelson and James Tobin. These mainstream Old Keynesians made the liquidity trap the hallmark of what Samuelson labeled Neoclassical Synthesis Keynesianism. If the economy is enmeshed in the liquidity trap, then Old Keynesians argued that the Monetary Authority is powerless to lower the rate of interest to stimulate the economy no matter how much the central bank exogenously increased the supply of money. This view of the impotence of monetary policy was succinctly summarized in the motto ‘you can't push on a string.’ The liquidity trap implied that monetary policy would be powerless to stimulate the economy if it fell into recession. These Old Keynesians, therefore, proclaimed that deficit spending fiscal policy was the only policy action available to pull an economy out of a recession. This faith in deficit spending as the only solution for recession became the policy theme for ‘Keynesians’, even though Keynes's speculative motive analysis denies the existence of a ‘liquidity trap’....
In the decade after the Second World War, econometricians searched in vain to demonstrate the existence of a liquidity trap (that is, a horizontal segment of the speculative demand for moment) where monetary policy could not affect the interest rate. In a stunning volte face of the history of economy thought, Milton and his followers who accept the neutrality of money as an article of faith used this failure of econometricians as an attack on Keynes’s theory. Friedman’s motto ‘Money matters’ became an anti-Keynesian weapon. This may have been an effective argument against Old Keynesians who followed Samuelson’s lead in accepting the neutral money axiom. Keynes, however, explicitly declared that in his analysis money was never neutral, that is, that money matters in both the short run and the long run in the real world” (Davidson 2002: 95).
Keynes also conceived the speculative demand for money as a rectangular hyperbola (Davidson 2002: 94–95), and we can turn to the General Theory to confirm that Keynes did not think the liquidity trap existed in the real world:
“There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest” (Keynes 2008 [1936]: 187).
The reason why monetary policy can be impotent and ineffective in recessions, depressions or periods of high involuntary unemployment where expectations have been shocked is that we have an economy with endogenous money, subjective expectations and shifting liquidity preference. A government can massively increase the private banks’ excess reserves by quantitative easing (QE), as seen in Japan from 2001 to 2006, and in the US and the UK from 2009, but that will not increase investment, spending or employment significantly, unless that money is injected into the economy by private debt. But it is precisely the collapse of expectations and confidence that destroys the demand for credit and the willingness of banks to extend credit. Banks may prefer to hold their excess reserves, and private individuals, households and businesses may be deleveraging (especially after an asset bubble and excessive private sector debt), and unwilling to take on new debt, while the economy is hit by debt deflation. The impotence of monetary policy in such circumstances is indeed a reality and the remedy is fiscal policy. But the neoclassical synthesis Keynesian idea of the liquidity trap is simply not needed to explain this phenomenon.

QE was a radical monetary policy justified by mainstream economics. It is the New Consensus macroeconomics, monetarism and conservative New Keynesianism that emphasises the use of monetary policy, while neglecting the role of fiscal policy. In contrast, liberal New Keynesians and Post Keynesians emphasise the role of fiscal policy and the ineffectiveness of monetary policy.


Davidson, P. 2002. Financial Markets, Money, and the Real World, Edward Elgar, Cheltenham.

Keynes, J. M. 2008 [1936]. General Theory of Employment, Interest and Money, Atlantic Publishers, New Delhi.


  1. Thank you for finally clarifying this. I had suspicions, but I still had no idea.

    Do you think that various American New Keynesians are slowly changing their minds towards more orthodox thinking closer to Keynes? Many Keynes-derived economics columnists have been writing about their disillusionment with mere use of monetary policy in recessions.

  2. "Do you think that various American New Keynesians are slowly changing their minds towards more orthodox thinking closer to Keynes? "

    Most of the New Keynesians simply use "liquidity trap" in the weak/loose sense of low interest rates or zero interest rates (ZIRP) being unable to stimulate the economy. As I said above, that definition is not objectionable.

    "Many Keynes-derived economics columnists have been writing about their disillusionment with mere use of monetary policy in recessions."

    Yes, that is very true.

    And they now have astonishing proof of how weak monetary policy can be in these circumstances: with the trillion or so dollars created as excess reserve for banks by the Fed in the massive asset swaps we call quantitative easing (QE), this has still not made much dent on unemployment or investment.

    Astute observers could have pointed to the essential failure of QE in Japan from 2001 to 2006, in which price deflation continued until 2006.