Liquidity Traps: How to Avoid Them and How to Escape Them

Abstract

The paper considers ways of avoiding a liquidity trap and ways of getting out of one. Unless lower short nominal interest rates are associated with significantly lower interest volatility, a lower average rate of inflation, which will be associated with lower expected nominal interest rates, increases the odds that the zero nominal interest rate floor will become a binding constraint. The empirical evidence on this issue is mixed. Once in a liquidity trap, there are two means of escape. The first is to use expansionary fiscal policy. The second is to lower the zero nominal interest rate floor. This second option involves paying negative interest on government 'bearer bonds'-coin and currency, that is 'taxing money', as advocated by Gesell. This would also reduce the likelihood of ending up in a liquidity trap. Taxing currency amounts to having periodic 'currency reforms', that is, compulsory conversions of 'old' currency into 'new' currency, say by stamping currency. The terms of the conversion can be set to achieve any positive or negative interest rate on currency. There are likely to be significant shoe leather costs associated with such schemes. The policy question then becomes how much shoe leather it takes to fill an output gap? Finally the paper develops a simple analytical model showing how the economy can get into a liquidity trap and how Gesell money is one way of avoiding it or escaping from it.

Avoiding Liquidity Traps

“…Because the nature of this undesirable equilibrium is identical to that identified in this paper, the long-run restrictions that are capable of eliminating liquidity traps in the continuous-time model will also be applicable under discrete time. Buiter and Panigirtzoglou (1999) have proposed the use of Gesell taxes on monetary balances as a way to avoid liquidity traps. A Gesell tax can be interpreted as a negative interest rate on money.…”

The zero-interest-rate bound and the role of the exchange rate for monetary policy in Japan

“…Goodfriend (2000), Buiter and Panigirtzoglou (1999) and Buiter (2001) discuss how the zero bound may be circumvented by imposing a tax on currency and reserve holdings.…”

Negative nominal interest rates: history and current proposals

“…Buiter and Panigirtzoglou (1999) trap is that the lower bound on interest rates might prevent the economy to achieve the inflation target. By setting the interest rate on currency sufficiently negative, however, any inflation target can be achieved.…”

“…The common feature of these model based studies of the Gesell tax and negative interest rates is the focus on overcoming the zero bound and the corresponding liquidity trap andapart from the ad-hoc model of Buiter and Panigirtzoglou (1999) -the use of Walrasian DSGE models. However, in all of these models, money has no essential role and is held only because it enters the utility function directly.…”

“…273-277). Some authors nevertheless took up Gesell's proposal of a tax on money as a means of overcoming the zero bound on interest rates, as for example, in Goodfriend (2000), Buiter and Panigirtzoglou (1999;, Fukao (2005) andBuiter (2005a,b;. It was only the current crisis with central bank rates close to zero and 18 Krugman (1998), in his seminal work, argued that Japan faced a liquidity trap like situation at that time.…”