the nature of Zero Lower Bound and the Liquidity Trap

Paul Krugman @paulkrugman

Friends tell me that this tweet was obscure — and it seems that many people, even in the finance world, don't get why velocity is unhelpful now. So, a thread 1/ twitter.com/paulkrugman/st…

Paul Krugman @paulkrugman

Thinking of this in terms of the velocity of money is itself a misunderstanding. When you're in a liquidity trap, with short-term rates near zero, the quantity of money is both endogenous and irrelevant 2/

2021-10-26 21:12:30

Paul Krugman @paulkrugman

Start with what happened in the first few years of the financial crisis and aftermath. Here's the monetary base, which is what the Fed controls directly, one measure of the money supply, and nominal GDP 2/ pic.twitter.com/6FUon6sHJG

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Paul Krugman @paulkrugman

Obviously monetary base (M0) grew enormously, M2 some but not much, GDP even less. So as a matter of arithmetic velocity of either M0 or M2 fell. But why? Because M0 was in a fundamental sense disconnected from GDP 3/

Paul Krugman @paulkrugman

Normally an open market operation, in which the Fed increases the monetary base by buying Treasuries, has major effects because M0 is the medium of exchange, which means that people hold it despite a zero interest rate for the sake of liquidity 4/

Paul Krugman @paulkrugman

So increasing M0 increases liquidity, which sort of rolls through the economy via lower interest rates. But from late 2008 on the interest rate on short-term Treasuries was essentially zero, which meant that holding monetary base was costless 5/

Paul Krugman @paulkrugman

And that in turn meant that at the margin M0 and Treasuries were perfect substitutes — two assets with the same (zero) rate of return. Conventional open-market operations therefore did nothing — investors were already saturated with liquidity, increasing M0 added nothing 6/

Paul Krugman @paulkrugman

That's why we call it a liquidity trap. Normal monetary policy becomes irrelevant. Huge increases in M0 had basically no effect on GDP. I'll get into slight complications in a second, but that's the key insight 7/

Paul Krugman @paulkrugman

And when M0 doesn't affect GDP, a rise in M0 will, as a matter of arithmetic, reduce the ratio of GDP to M0 — velocity. But it makes no sense to focus on that ratio 8/

Paul Krugman @paulkrugman

Think of two gears that normally mesh with each other, but are currently separated. If we spin gear A faster and nothing happens to gear B, would it make sense to say that the gearing ratio has declined? No, they're just spinning independently 9/

Paul Krugman @paulkrugman

OK, two complications. The Fed engaged in unconventional open market operations, buying longer-term bonds etc — QE. These may have had some effect. But if so, it wasn't through anything like the normal relationship btwn money supply and GDP 10/

Paul Krugman @paulkrugman

Also, people who talk about the money supply usually mean an aggregate like M1 or M2. Normally the Fed can target those aggregates via its control of M0. But in a liquidity trap those gears are *also* disconnected. Increase bank reserves and they just sit there 11/

Paul Krugman @paulkrugman

So M1 and M2 are no longer policy variables, even potentially; they're determined mainly by demand for deposits, and the Fed can't change that through its operations. As I said, money is endogenous 12/

Paul Krugman @paulkrugman

Again, in an arithmetic sense the money multiplier has declined, but that's not a helpful way to describe what's going on, which is instead that the gears have simply been disengaged 13/

Paul Krugman @paulkrugman

So in a zero-rate environment, velocity and similar concepts just don't help you understand what's happening. If anything, they create confusion by suggesting that the size of the monetary base matters under conditions where it doesn't 14/

Paul Krugman @paulkrugman

Again, I went through all this in 1998 (and James Tobin could have told you most of it decades earlier) 15/ brookings.edu/bpea-articles/…