Arnold Kling

The Fed is not Trapped

Arnold Kling, Great Questions of Economics
Previous Entry Next Entry

Paul Krugman could not find room in his twice-weekly Bush-bashing column for this interesting piece of economic analysis by a macroeconomic policy consultant, so he forwarded it to Brad DeLong. The issue under discussion is a possible "liquidity trap," in which the main Fed instrument, the Federal Funds rate, falls to zero. With low or negative inflation, this might not be expansionary. However,

"We do not have a zero bound problem except at the federal funds frontier," one official said, "and the Fed is perfectly capable of operating all along the yield curve. We can expand our balance sheet and buy all down the curve." Of course. And as another official put it, "we are looking at the Federal Reserve Act again to see what our options are. They are actually quite powerful."

That is, if the Federal Funds rate drops to zero, the Fed could still buy long-term bonds. For that matter, it could buy mortgage-backed securities or corporate bonds. The point is that a liquidity trap may not be a constraint on the Fed's ability to conduct expansionary operations.

Discussion Question. Even though the Fed may have room to reduce interest rates, an old economic debate is whether lower interest rates can increase investment in a depression. The phrase used is that the Fed is "pushing on a string." Can one be confident that lower interest rates would be sufficient to pull the economy out of a deep slump?

Return to top