Is There a Liquidity Trap in Keynes Theory –Answered !

This article provides a answer to the evidence of liquidity trap in Keynes theory.

There have been several attempts to study the characteristics of the liquidity preference curve in more detail.

First of all, is there any evidence of a liquidity trap? Keynes emphasis on the speculative demand for money and the liquidity trap seems to have been exaggerated.

No evidence has been found which goes to support the existence of the liquidity trap.

There has been a good deal of research work in recent years on liquidity trap to find out whether it does really exist? The work of James Tobin, soon after World War II showed that there was a liquidity trap, because the demand curve for idle balances approached the horizontal as the rate of interest fell. This study was published in 1947 but the recent research work failed to establish any such relationship like liquidity trap. The main limitation in Tobin’s study was that he did not allow for the influence of total wealth on liquidity preference.

Later on, another study which detected a significant speculative demand for money (El-Mokadem, 1969) implied that this was a short-run phenomenon, since the normal rate of interest adjusted rapidly to the current rate. If a liquidity trap exists, one would expect the elasticity of Ma with respect to r to be greater at low than at high interest rates. Bronfenbrenner and Mayer (1960) and Laidler (1966) have tested to see whether this was so in American experience, using both M₁ and M₂ measures of money and both short and long-term interest rates; but they found no evidence to support the liquidity trap hypothesis.

The main difference between the modern demand functions and that derived from the Keynesian approach is the former’s emphasis on wealth as opposed to current income, and the omission of any unstable element, such as is implied by the speculative demand for money. Finally, there is nothing in the asset approach to suggest that the elasticity of demand for money with respect to the rate of interest will become infinite at some positive rate of interest—the theory does not predict that there will be a liquidity trap.

The evidence is definitely inconclusive. It is tempting and helpful to say that there is a liquidity trap because it is essential and integral to the Keynesian model of liquidity preference. The idea that there will be some low positive rate of interest at which the demand for money becomes infinite is very appealing. British experience around 1957, when the Chancellor of the Exchequer, Dr. Dalton, attempted to reduce the long-term interest rate to 2½ per cent, shows that liquidity trap does sometime operate.

Dalton’s efforts to reduce the long-term interest rate had to be given up because no one was prepared to take bonds at such low rates of interests. The issue, in spite of its great importance, remains unsettled. One can only hope that further econometric work will resolve it one way or the other before too long.

Although it is an interesting and presumably possible phenomenon, the actual appearance of a liquidity trap is obviously a rarity. Seldom do interest rates reach the low level at which the wealth holders hold the expectations necessary to produce a liquidity trap. The closest approximation to a liquidity trap in recent years has been the U.S.A. experience during the period immediately following the great depression—a period now more than forty years behind us.

Although it is now viewed as an extreme case, the liquidity trap plays an important part in Keynes’ General Theory, written at a time of depression—when the existence of liquidity trap appeared to be more of a reality than a possibility. Liquidity trap has certain important policy implications—for example, a perfectly elastic demand for money poses a serious problem for the monetary authority because it cannot reduce the rate of interest in spite of an increase in the supply of money.

As such, it prevents the monetary policy from being put to use to this end. Monetary policy, on account of sticky rate of interest becomes incapable of reducing unemployment. We have already learnt by now that wage or price rigidities caused unemployment and that it could be removed by suitable fiscal or monetary policy. However, the theoretical possibility of liquidity trap shows that when the rate of interest becomes sticky or rigid, monetary policy fails (assuming that there is no real balance effect in the ADF).

The theoretical innovation has had a great impact on the development of economics. If monetary policy is useless in bringing about full employment, the alternative was seen in pursuing an active fiscal policy—spending more and taxing less. These were the twin problems of liquidity trap and secular stagnation that gave great impetus for a detailed understanding of fiscal policy. It will be no exaggeration to say that fiscal policy became more acceptable as a major technique of economic stabilization. Money does not matter—became a catch phrase amongst economists during the 1940s and the 1950s.

Liquidity trap became the chief reason for monetary policy being relegated to the background. However, a reaction set in during the mid-1950s and through the 1960s and the 1970s. There may be a liquidity trap—the critics said—but has anybody ever seen one? Latest research and empirical studies did show that money does matter.

In this respect contributions of Milton Friedman of the Chicago School and his followers are worth mentioning. Despite, strong bias which had developed against monetary policy—Friedman rehabilitated the same in recent years. Hence, the implication of liquidity traps, that even when, wages and commodity price are flexible, the interest rate rigidity can lead to either persistent deflation or unemployment.