America's Looming Liquidity Trap

In October 2008, the US unemployment rate hit 6.5%, a 14-and-a-half year high, as announced by the Labor Department. This lofty rate is likely to increase in the coming months in the wake of the ongoing financial crisis and adjustments in the real estate market. It also comes despite two 50 basis point cuts in the target federal funds rate made by the Federal Reserve during that month. These interest rate reductions brought the target fed funds rate down to 1%, a very low target rate by historical standards and close to the nominal rate floor of 0%. The Federal Reserve therefore finds itself in the thorny situation of having only 100 basis points left to work with for possible target rate cuts. (Note that a basis point represents 1/100th of a percentage point, so 1% is 100 basis points.)

The fed funds rate cannot go below 0% because a transaction at a negative nominal rate implies a negative nominal cost of borrowing funds. Furthermore, that implies a positive nominal payoff to the borrower and a positive nominal loss to the lender. Under typical, positive rates of inflation, the real costs and payoffs are amplified. This is shown in the following Fisher equation where i is the nominal interest rate, r is the real interest rate, and is the inflation rate:


This floor for the nominal fed funds rate brings up the very real possibility that the US will soon be mired in a liquidity trap—a situation in which "the monetary authority is unable to stimulate the economy with traditional monetary policy tools." One explanation for this weakness of monetary policy comes from the analysis on the real interest rate given above. In difficult economic times, why would financial institutions take on the risk of lending out money to a borrower who may default on the loan when the real return on even a fully repaid loan is negative!

An excellent source on how our nation might remedy its liquidity trap is given by the 2008 Nobel Laureate in Economic Sciences, Paul Krugman. His 1999 article "Thinking About the Liquidity Trap" offered policy solutions for springing the Japanese economy from the type of liquidity trap that now threatens the United States. Krugman's figure 1 from that paper shows a nice IS-LM example of the ineffectiveness of monetary policy. Wikipedia provides a good introduction to the IS-LM model. Below I present a modified version of Krugman's figure 1, in the context of current US interest rates, to represent traditional monetary expansion with a looming liquidity trap.



An economy may also happen to face declining consumption expenditures, as the US currently does, due to concerns about a rising unemployment rate, which can result in lower exogenous consumption and a falling marginal propensity to consume. In that case, the resulting leftward movements of the IS curve make monetary policy even less effective. Krugman's solution to the scenario is to have the monetary authorities credibly commit to sustained higher future inflation. The expectation that such higher inflation will eat away at the purchasing power of cash holdings should convince consumers to ramp up their spending and move the IS curve rightward.

President-elect Obama and the new Congress will undoubtedly undertake expansionary fiscal policy to attempt to move the IS curve rightward. However, our already massive national debt and the likelihood of waste involved in government spending, support Krugman's solution. Our newly elected officials and the Federal Reserve Board are facing unenviable policy choices.

Discussion Questions

1. Suppose that you were in control of US fiscal and monetary policy. What policies, if any, would you implement to improve US economic conditions?

2. Do you believe that America will soon face a liquidity trap? Why or why not?

3. The International Monetary Fund forecasts that the world's rich economies will collectively experience economic contraction for the first time since World War II. When was the last time America faced a liquidity trap? What circumstances led to that liquidity trap environment?

The Phillips Curve and the Federal Reserve

The Phillips Curve is a concept often covered in introductory macroeconomics. However, in some economic and political circles, the concept is considered outdated and useless. Some economists and commentators, such as Lawrence Kudlow, might go as far as to say that the Phillips Curve is dead. Why does the Phillips Curve command such controversy? Is it as irrelevant as some economists claim?

The traditional Phillips Curve is the trade-off between the inflation rate and the unemployment rate. Many economists in the 1960s thought that the Federal Reserve or Congress could permanently lower the unemployment rate by increasing the inflation rate. The trouble is, the traditional Phillips Curve violates one of the central tenets of economics: the classical dichotomy. According to the classical dichotomy, nominal variables do not affect real variables. Consider a simple example:

I hold a bag of apples that weighs 5 pounds. The weight (i.e., the force exerted on my arm) is a real variable and the unit of measurement (i.e., pounds) is a nominal variable. Suppose the U.S. government passes a new law that says all measurements must conform to the metric system. Now the same bag of apples weighs 2.27 kilograms. Notice that the nominal variable (how the weight is measured) has absolutely no effect on the real variable (the force exerted on my arm).

The traditional Phillips Curve is in direct contradiction of the classical dichotomy. The Phillips Curve implied that the government could effectively reduce the unemployment rate (a real variable) by changing how fast overall prices are growing in the economy (a nominal variable). Though the traditional Phillips Curve held up well in the 1960s, the 1970s would usher in the downfall of the traditional Phillips Curve.

In the 1970s, the trade-off between the unemployment rate and the inflation rate seemed to fall apart. The United States experienced soaring overall prices and rising unemployment. In other words, there appeared to be an upward-sloping relationship between the inflation rate and unemployment rate. Due to this fact, many economists declared the Phillips Curve to be dead.

Due to the abrupt change in the correlation between inflation and unemployment, several theories were proposed as alternatives to the Phillips Curve. These theories include the Real Business Cycle (RBC), Rational Expectations, and Monetarism. Often times these theories are called “New Classical” economics because they promote the classical dichotomy.

Under heavy pressure from competing theories and empirical evidence, a new school of thought known as “New Keynesian” economics sought microeconomic foundations for the Phillips Curve. Edmund Phelps, the Nobel Laureate in 2006, augmented the traditional Phillips Curve by adding the critical role of expectations. Under the expectations-augmented Phillips Curve model, a trade-off between inflation and unemployment does exist but only in the short run. According to the model, inflation expectations adjust to return the economy to its natural rate of unemployment (i.e., an unemployment rate consistent with non-accelerating inflation). George Akerlof, the Nobel Laureate in 2001, provided behavioral explanations for the trade-off. Subsequent works by economists, such as David Romer and Greg Mankiw, provided additional microeconomic foundations for a short-run trade-off.

Through all the intellectual turmoil, most economists agree on the following:

1. There is a short-run trade-off between the inflation rate and the unemployment rate.
2. In the long run, the inflation rate adjusts to restore the natural rate of unemployment. Hence, policy makers cannot permanently push unemployment below its natural rate by permanently increasing the inflation rate.

How well does the modern Phillips Curve describe the real world, and do practitioners actually use the modern Phillips Curve? James Stock and Mark Watson, authors of a famous introductory econometrics textbook and well-respected econometricians, empirically showed that the modern Phillips Curve bested all other alternatives in terms of forecasting inflation. Ben Bernanke, chairperson of the Federal Reserve, professed publicly here and here on the importance of the modern Phillips Curve in the Fed's inflation forecasts, which ultimately influence monetary policy.

The Phillips Curve has changed over the past 40 years, but it is very much alive as a reference for monetary policymakers.

Discussion Questions:

1. Go to the Bureau of Labor Statistics web site and pull data on the national unemployment rate and the CPI inflation rate. For your convenience, I have included the spreadsheet here. Does there appear to be a trade-off between inflation and unemployment between January 2001 and December 2001?

2. Does there appear to be a trade-off between January 1997 and October 2007?

3. Why do you think an increase in the inflation rate decreases the unemployment rate in the short run? Why do you think a decrease in the unemployment rate increases the inflation rate in the short run?

Inflation Gone Wild

With an annual inflation rate of 1,600%, Zimbabwe currently holds the world title for fastest-increasing prices. As the late Milton Friedman put it, “Inflation is always and everywhere a monetary phenomenon. To control inflation, you need to control the money supply.” The inflation cure seems simple to understand from a textbook perspective: drastically cut back the money supply in order to lower the expected inflation rate.

Unfortunately, the cure might be worse than the disease. With the current unemployment rate at 80%, drastic cuts in the money supply could increase unemployment and cause a coup d'état before the expected inflation rate falls. The monetary contraction is inevitable if Zimbabwe wishes to tame the inflation monster, and the International Monetary Fund has urged the government to liberalize its exchange rate regime as a means to cushion the unemployment effects.

In order to understand the IMF’s position on Zimbabwe’s exchange rate, we must examine how maintaining an overvalued currency might contribute to soaring inflation, and how floating the currency might provide relief to both inflation and unemployment.

The graph on the left shows the market for Zimbabwean dollars. Assume that the government fixes the exchange rate at E1. A fixed exchange rate is the official value of the currency despite fluctuations in supply and demand. Initially, the official value equals the market value where D1 intersects S1 (point A). Then, due to unsustainable fiscal deficits and government land reforms that usurp private property, foreign investors flee Zimbabwe. Consequently, the demand for Zimbabwean dollars decreases from D1 to D2.

If Zimbabwe were under a floating exchange rate regime, the fall in demand for Zimbabwean dollars would result in the depreciation of the currency from E1 to E2 (point B). But because Zimbabwe’s government insists on a fixed exchange rate regime, the fall in demand for Zimbabwean dollars will cause a surplus of Zimbabwean dollars (Q1 - Q2). At point C, the currency is considered overvalued because the official value is greater than the market value. In order to eliminate downward pressures on the currency, Zimbabwe will instruct its central bank to buy the surplus of Zimbabwean dollars (and sell U.S. dollars), which will return the market to point A. Zimbabwe's central bank will eventually deplete its U.S. dollar reserves as the economy deteriorates from questionable domestic policies, and will borrow U.S. dollars in order to maintain the fixed exchange rate.

Since the loans are denominated in U.S. dollars, Zimbabwe must make periodic payments in U.S. dollars or face getting cut off from all sources of international capital. Due to disastrous domestic policies, the government has little tax revenue to make those periodic payments, and the only way to service their international debts is to print more money, just as Germany did after World War I. As the central bank expands the money supply to pay international debts, inflation increases, which places additional downward pressure on the Zimbabwean dollar: as foreigners demand less and less of the failing currency, Zimbabwe has to print more and more money, and sooner or later, everything will spin out of control.

One solution is to eliminate the fixed exchange rate regime altogether and allow the Zimbabwean dollar to float freely. If the currency were allowed to float today, its value would fall tremendously, which would stimulate exports and reduce imports. The graph on the right shows that as the exchange rate falls from E1 to E2, net exports increase from NX1 to NX2. A floating exchange rate would boost job creation as the central bank institutes the tough medicine of curing inflation by drastically reducing the money supply.

Discussion Questions

1. If the fixed exchange rate regime were eliminated, what would happen to the size of Zimbabwe's international debts in terms of Zimbabwean dollars? Would it increase or decrease?

2. The central bank has recently declared inflation illegal. How do price controls affect domestic markets like those for corn, wheat, electricity, and labor?

3. This analysis assumes that Zimbabwe's reduction in real GDP is due to domestic policies such as unsustainable fiscal deficits and poor private property rights. How might hyperinflation directly contribute to higher unemployment?