A liquidity trap is defined as a situation in which the short-term nominal interest rate is zero. The old Keynesian literature emphasized that increasing money supply has no effect in a liquidity trap so that monetary policy is ineffective. The modern literature, in contrast, emphasizes that, even if increasing the current money supply has no effect, monetary policy is far from ineffective at zero interest rates. What is important, however, is not the current money supply but managing expectations about the future money supply in states of the world in which interest rates are positive.
KeywordsArbitrage Bank of Japan Central banks Commitment to optimal policy Deflation bias Euler equation Expectations Foreign exchange interventions General equilibrium Great Depression Incentive compatibility Inflation bias Inflation targeting Inflationary expectations Keynesianism Krugman, P. Kydland, F. Liquidity trap Monetary policy Money supply New Keynesian Phillips curve Nominal interest rate Output gap Prescott, E. Public debt Quantity theory of money Real government spending Rules versus discretion Taylor rule Zero bound (on shortterm nominal interest rate)
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