A Microeconomic Theory of the Liquidity Trap (Classic Reprint)

Nathaniel J. Mass Assistant Professor of Management Director, System Dynamics National Modeling Project Alfred P. Sloan School of Management Massachusetts Institute of Technology Cambridge, Massachusetts 02139 I. INTRCCOC nON Forty years after publication of Keynes General Theory, debate continues over the meaning and validity of Keynes ideas. A mong tlie most controversial of these is the liquidity trap. The liquidity trap is a conditicxi in which monetary expansion has little or no effect on real investment or income, but instead mainly induces increased idle balances. The concept of a liquidity trap has had important influence on post-K eynesian thinking. For example, Johnson (1961) attributes to Keynes a dynamic analysis tht explains why unemployment disequilibrium can be sustained for a long time despite monetary (or other policy) intervention. Similarly, Lerner (1961) describes policy signficance of the Keynesian Special Case viere fiscal policy has to bail out monetary policy. The liquidity trap underlies the interpretation of Keynes that attributes low leverage to monetary policy and much greater force to fiscal policy. But despite agreenent over the theoretical significance and policy relevance of liquidity-trap behavior, two main areas of controversy about the liquidity trap persist. One area revolves around Keynes own contribution; in particular, whether Keynes himself presented a cogent explanation of the liquidity trap and even whether he espoused its importance. The second area of controversy concerns adequacy of any theory advanced to explain the liquidity trap. Leijonhufvud (1968) has pointed out the ambiguity of Keynes own cc Mitributicai. In the Treatise on Money, Keynes argues that if a contraction were allowed to gather momentum, only open market operations to the point of saturation would exert any appreciable effect.
(Typographical errors above are due to OCR software and don't occur in the book.)

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