| Because the nominal interest rate cannot become negative,
the LM curve tends to flatten out at low interest rates. When the LM curve
is flat, Keynesian theory with static expectations predicts that monetary
expansion -- a rightward shift of the LM curve -- will not be successful
in the stimulating the economy. Of course, there is more money in the economy,
but monetary expansion stimulates the economy by encouraging more real
consumption and investment through lower interest rates. |
| In the late 1990s, a number of economists, Paul Krugman
prominent among them, began to argue that Japan was stuck in a liquidity
trap. Nonetheless, they argued, monetary expansion could be used to stimulate
the economy if it were conducted appropriately. The readings below are
two essays from Krugman. The first, dated August 1998, relates the story
of a babysitting cooperative that found itself in a situation analogous
to a liquidity trap; it's an insightful piece. The second, from March 1999,
was written at a brief point in time when Krugman hoped that policies he
had been pushing were finally being put in place by the Bank of Japan. |
In order to fully relate the arguments to the formal
model we have covered in class, recall the following:
| Sustained monetary expansion will lead to higher inflation
(the classical model as a long-run model). |
| This will raise expectations about the price level (see
the components of the IS curve), and so drive down the expected real rate
of interest). |
| An increase in the expected price level will shift the
IS curve to the right. |
|