Liquidity Traps: A Unified Theory of the Great Depression and Great Recession

Table of Contents

• Introduction 3
• The Root Causes of the Liquidity Trap 9
• The First Building Block of a Liquidity Trap: A Negative Natural Rate of Interest 9
• The Natural Rate of Interest and the Liquidity Trap 9
• Setting the stage: Some Data from U.S./ Great Depression and Great Recession and Japan's Long Recession 10
• Fast Moving Forces and a Negative Natural Rate in the Short-Run 11
• Slow Moving Forces and a Negative Natural Rate of Interest in the Long Run: The Secular Stagnation Hypothesis 16
• The second building block of a Liquidity Trap: Paper Currency 19
• Paper Currency, the Zero Lower Bound, the Monetary Base, and the Effective Lower Bound 20
• Price Level Determination when the Natural Rate of Interest is Negative in the Short-Run 21
• Price Level Determination if the Natural Rate of Interest is Negative in the Short and Long-Run 25
• An Empirical Prediction Based on the Two Building Blocks: Irrelevance Results for Monetary Expansion in a Liquidity Trap if Expectations of the Future Policy Reaction Function are Fixed 25
• A Standard Monetary and Fiscal Policy Regime and a Negative Natural Rate of Interest in the Short-Run 30
• The Canonical New Keynesian Model and the Liquidity Trap 30
• Setting the Stage: Data from the US Great Depression and Great Recession 30
• The Model 31
• An Analytic Example 35
• Calibrating the Great Recession and the Great Depression and the Role of the Inflation Target as a Buffer 40
• Is Market Self-Equilibrating at the ZLB? The Paradox of Price Flexibility 42
• What Can Fiscal Policy Do Under the Standard Monetary and Fiscal Policy Regime? 45
• Fiscal Multipliers: The Theoretical Prediction of the New Keynesian Model under the Standard Monetary and Fiscal Policy Regime 45
• Fiscal Multipliers: Brief Summary of Recent Evidence 50
• Fiscal Austerity and Deficits 51
• Deficits and confidence 53
• New and Old Fiscal Multiplier: Introducing Heterogeneous Agents 54
• Alternative Stochastic Process for Exogenous Shock and the Fiscal Intervention 58
• Fiscal Policies That Circumvent the ZLB 59
• Reconciling Contradictory Findings 62
• Aggregate Supply Shocks, Supply side Policies, and the Paradox of Toil under the Standard Monetary and Fiscal Policy Regime 63
• The Paradox of Toil: An Analytic Result 63
• The Paradox of Toil: Empirical Evidence 64
• The Great Recession and the Debate on Structural Reforms in Europe 66
• The Great Depression and the National Industrial Recovery Act of 1933 67
• Credit Policy and Central Bank Lending Facilities under a Standard Monetary and Fiscal Policy Regime 68
• Quantitative Easing and the Feds Liquidity Facilities 69
• Quantitative Easing 2, 3, 4, MEP and Beyond 71
• Policy Regime Changes: Optimal Monetary Policy Regimes and a Negative Natural Rate of Interest in the Short-Run 72
• The Great Recession and the Deflation Bias: Contrast of the Optimal Commitment Monetary Policy Regime and the Optimal Monetary Policy Regime in a Markov Perfect Equilibrium 73
• The Optimal monetary policy commitment regime with a Negative Natural Rate in the Short Run 73
• How can the Optimal Monetary Policy Commitment Regime be Implemented? 75
• The Deflation Bias: Optimal Monetary Policy Regime in a Markov Perfect Equilibrium with a Negative Natural Rate in the Short Run 77
• Empirical Evidence on the Effect of Forward Guidance 78
• Did the Federal Reserve Follow the Optimal Monetary Policy Commitment Regime during the Great Recession? 81
• Empirical Implication of the Optimal Monetary Policy Commitment Regime 83
• Taking stock: What was the Nature of the Monetary Policy Regime during the Great Recession? 85
• The Great Depression and Optimal Joint Monetary and Fiscal Policy Regime in a Markov Perfect Equilibrium with Additional Institutional Constraints 87
• Hoover Regime and the Great Depression in 1929-1933 91
• FDR Regime Change and the Recovery 1933-1937 92
• The Mistake of 1937 and the Recovery of 1938 95
• Long-Run Recessions and a Negative Natural Rate of Interest in the Short and the Long Run 98
• A Simple Modern Model of Secular Stagnation 100
• Policy Implication of Secular Stagnation 103
• Abenomics: Japan and the Long Recession 104
• Future Directions for Research: What will be the New Normal? 106
• Conclusion 108