## Monday, March 21, 2011

### Kling’s Misunderstanding of the IS-LM Model and Liquidity Traps

Now I see how Arnold Kling has gotten so confused:

The difference being that you might one day see a unicorn.
A liquidity trap requires
1. Low nominal interest rates. (The nominal interest rate is the interest rate as stated.)
2. High real interest rates, due to low or negative inflation.* (The real interest rate is the nominal interest rate minus the rate of expected inflation. If the nominal interest rate is 5 percent and the expected inflation rate is 2 percent, then the real interest rate is 3 percent.)
3. No way for the monetary authority to escape from (1) and (2). Hence the term trap.
(*In this post, Paul Krugman surprises me by stating implying (as far as I can tell) that high real interest rates are a sign that we are not in a liquidity trap. That is completely the opposite of my understanding.

Kling must be assuming away the possibility that the IS curve has shifted inwards. But isn’t the message here that the demand for investment has fallen and/or the national savings schedule has risen so much that even with very low interest rates, investment would not equal national savings at full employment?

Ken Houghton said...

"But isn’t the message here that the demand for investment has fallen and/or the national savings schedule has risen so much that even with very low interest rates, investment would not equal national savings at full employment?"

Yes. No. Maybe.

Without going into which is most applicable, S!=I; that is, some money is being kept but not used.

The problem is that you have to take a step back and ask how real the money being "kept" is.

Businesses--which depends on such decisions--have clearly decided that some of that "kept" money isn't real. The proof is that they are not screaming from the highest bower that paying the banks an arbitrage rate for Excess Reserves is slowing the economy.

Either businesses don't think they can make a real profit of 0.25% more than they currently do through expansion and/or streamlining, or (now that the Fed has admitted that The Usual Suspects--BAC, The Big C, and a few others--may not pay dividends) that the excess is about as real as that old rival of Scrooge McDuck's who inflated (literally) a tarp under his lifetime savings in order to appear more prosperous.

If it's the first, we're not in a liquidity trap--it's "just" a failing of Aggregate Demand. If it's the second, then maybe S=I is still true, but S!=S(off). And until those two come back into line, you're going to be in a liquidity trap. (That the liquid is sand at best, quicksand at worst, is moot.)

kevin quinn said...

Maybe the confusion has to do with the difference between the natural rate and the actual real rate. The liquidity trap is a situation in which the natural rate is below the negative of expected inflation. Then even a nominal rate of zero would leave the actual real rate above the natural rate. For an economy with a high positive natural rate - such as the Reagan economy of the 80's - the fact that the actual real rate cannot be below the negative of the rate of inflation obviously is no problem.

This way of thinking about the trap also puts the efficacy of fiscal policy in a new light: the point of fiscal expansion is then precisely to raise the natural rate so that it is above rather than below the negative of expected inflation.