Taxes and the liquidity trap

How often have you heard it? Monetary policy is impotent because interest rates are very low and if you increase the money base banks will just hoard all the money and will not lend out anything. Market Monetarists of course know that this is nonsense, but we have all also tried to explain this to people that seem unable to listen to the arguments.

Here is an idea how you make people listen. If somebody refuses to accept the power of monetary policy just ask them the following question: “So if an increase in the money base will not be able to increase nominal GDP why should we then have taxes?”

Hence, if there indeed were a liquidity trap there would indeed be a free lunch – you could pay for all expenditure with newly printed money from the central bank without getting inflation. This statement will normally upset people quite a bit and they will scream at you “then we will get hyperinflation!”…when you hear that you know you won the argument and you just reply “Q.E.D.”.

PS I am not suggesting this – exactly because I know there is no liquidity trap.

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3 Comments

  1. I’ve tried this argument. The retort is usually that monetary + fiscal works, but monetary by itself wont work.

    Reply
  2. The liquidity trap is nonsense because it assumes whatever the central bank purchases, sellers never want money to spend but only to hold. The most common reason anyone sells something is because they want to buy something else, even when interest rates fall near zero. The Fed merely has to be more selective about its purchases, since people are more likely than usual to hold more and spend less of the money.

    Basically, the liquidity trap posits than any change in the money supply is completely offset by changes in money velocity. I have never read a plausible explanation, outside of models with unrealistic assumptions, of what mechanism would make that happen. At best, changes in the supply of money will be partly offset by changes in the velocity of money, but that would be more a matter of central bank incompetence than a law of monetary economics.

    Reply
  3. Lee, there is no chance in hell that I would disagree with you on this one;-)

    Reply

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