Monday, October 5, 2009
Traps and multipliers
Tyler Cowen has a post where he says that it is inconsistent to hold both that there is a liquidity trap and that the fiscal multiplier is large. He says that if the government spends more on cement - say- when we are in a liquidity trap, the cement supplier will simply add the proceeds to his money hoards and that's the end of the matter. I find this puzzling, to say the least. The liquidity trap doesn't mean that you have an unlimited demand for money balances. It means that you regard money and bonds - due to the zero interest rate- as perfect substitutes. So monetary policy, which substitutes money for bonds in private sector balance sheets, can't work. In normal times, this substitution can't happen without a fall in the interest rate, which would then be stimulative. In a liquidity trap, giving the cement supplier, or anybody else, money in exchange for bonds doesn't change anything; but giving the cement maker money to produce cement increases her income, and thus, to some extent her spending, and thus someone else's income and yadda yadda. Am I missing something basic here?