Liquidity Claptrap

Economists are rarely satisfied with evidence that something works in practice. They tend to be more interested in whether it works in theory. In the case of monetary policy at low (or zero) inflation, the now famous theoretical conjecture is John Maynard Keynes's claim that when inflation is low and market interest rates are below 2 percent, monetary policy might be incapable of changing the interest rate, price level, or any other relevant variable. He gave the problem a name, liquidity trap. Paul Krugman and Takatoshi Ito conjecture that Japan is now in a liquidity trap, because short-term interest rates are near zero. Larry Summers argued a related proposition — that zero inflation is socially costly because it sets a lower bound for nominal interest rates. Monetary policy becomes ineffective: It cannot lower the short-term nominal rate or prevent falling prices from raising the real rate of interest. With money wages less than fully flexible, unemployment rises. The central bank is powerless to lower the short-term nominal interest rate once it reaches (or approaches) zero.