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Some Observations on the Return of the Liquidity Trap
By Scott Sumner
Introduction
By the mid-1990s, most macroeconomists had probably assumed that the concept of a "liquidity trap" was safely dead and buried. Many of the newer intermediate macro texts failed to even mention the term. It would hardly be the first time, however, that a seemingly discredited macroeconomic concept suddenly regained a measure of respectability. With prominent macroeconomists, such as Paul Krugman (1998), now offering advice on how Japan can escape from its liquidity trap, it is appropriate to look at some neglected historical and theoretical issues raised by that dubious concept.
Although it is easy to find definitions of the term "liquidity trap,"1 its original meaning and interpretation are somewhat unclear. For instance, what did Keynes actually intend when he used the term "liquidity trap" in the General Theory? How does the modern interpretation differ? How can we identify the existence of a liquidity trap? What policies can prevent its formation, or allow an economy to move out of an existing trap? What monetary policy is optimal in a liquidity trap? Until very recently, contemporary macroeconomists had given little thought to those questions. Many of the answers are surprising.
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