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What Became of the Liquidity Trap?: Anthony de Jasay
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If the economy fails to respond to the fiscal push, can recourse to more liquidity to float it off the sandbank? A cardinal assumption of Keynesian theory is that the demand to hold money becomes infinitely elastic at some low but still positive rate of interest. This rate is the "liquidity trap". Old-style central bankers may be spinning in their graves at the noise of "quantitative easing" as more and more debt securities are sucked up by the central bank and are replaced with more liquid money and near-money, yet the interest rate relevant to capital investment will not go any lower. Hence, no matter whether the economy is splashing ankle-deep or knee-deep in liquidity, investment will remain inadequate to dent unemployment. However, as we look at real numbers in money and capital markets since 2007, we are left wondering about what has become of the "liquidity trap"? The interest rate at the short end of the yield curve is as near zero as not to matter, and even at the long end it looks negligibly low if the riskless rate of just over 3 per cent is deflated by the probable rate of future inflation which, too, should hover near or above the 3 per cent level. In other words, if the risk-free real rate is in fact at about zero, there is in fact no such thing as the liquidity trap and at least for the present, it cannot be blamed for the economy idling along at the lower edge of the output gap.