How the Liquidity Trap Keeps Inflation Low

May 29, 2014

Many reasons have been given for the persistently low inflation the U.S. has experienced for the past few years. A recent article in The Regional Economist examines an alternative reason: the liquidity trap.

Typically, an increase in the money supply (such as the increase generated through the Federal Reserve’s large-scale asset purchases) causes inflation to rise as more money is chasing the same amount of goods. During normal times, inflation increases 0.54 percent for each 1 percent increase in the growth of money.1

However, Assistant Vice President and Economist Yi Wen and Research Associate Maria Arias, both of the Federal Reserve Bank of St. Louis, explain that, in a liquidity trap, investors choose to hoard the additional money resulting from an increase in the money supply rather than spend it because the opportunity cost of holding cash—the forgone earnings from interest—is zero when the nominal interest rate is zero. If this increase in money demand is proportional to the increase in the money supply, inflation will instead remain stable. If money demand increases more than proportionally to the increase in money supply, the price level falls.

In a paper last year, Wen argued that large-scale asset purchases by the Fed at the current pace could reduce the real interest rate by 2 percentage points, but would also put severe downward pressure on the inflation rate, among other effects. In The Regional Economist article, the authors argue that low inflation makes cash more attractive to investors, in turn making a liquidity trap easier to occur.

Wen and Arias wrote, “Therefore, the correct monetary policy during a liquidity trap is not to further increase the money supply or reduce the interest rate but to raise inflation expectations by raising the nominal interest rate. … Only when financial assets become more attractive than cash can the aggregate price level increase.”

Notes and References

1 “Normal times” refers to the postwar period prior to the Great Recession (1960-2007). The authors calculated the effect of changes in the money supply on headline consumer price index inflation using a linear regression model.

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