The Liquidity Trap, the Real Balance Effect, and the Friedman Rule

This paper studies the behavior of the economy and the efficacy of monetary policy under zero nominal interest rates, using a model with population growth that nests, as a special case, a more conventional specification in which there is a single infinitely lived representative agent. The paper shows that with a growing population, monetary policy has distributional effects that give rise to a real balance effect, thereby eliminating the liquidity trap. These same distributional effects, however, can also work to make many agents much worse off under zero nominal interest rates than they are when the nominal interest rate is positive. Inflation has come full circle. Low before 1960, it rose during the 1960s and peaked during the 1970s. From this peak, it fell during the 1980s, finally stabilizing during the 1990s at levels very similar to those prevailing before 1960. This same circular pattern appears in data from virtually all the major industrialized countries–in North America, in Europe, and in Asia–as shown, for example, by Mussa (2000, Table 1, p.1103). Monetary economists and central bankers have also come full circle. Concerned mainly with halting and reversing inflation's upward trend during the 1970s and 1980s, analysts and policymakers have more recently rediscovered some of the special problems that can arise under conditions of price stability. These problems received much attention long ago but were ignored for more than a generation. Now they have taken center stage once again. Chief among these problems are those associated with the liquidity trap, which, according (1999) reconsider the idea of the liquidity trap using state-of-the-art monetary models in which optimizing agents have rational expectations. In both Krugman's cash-in-advance model and Svensson's money-in-the-utility-function model, households become willing to hoard any additional money that the government chooses to supply after the nominal interest rate reaches its lower bound of zero. The central bank then loses control of the price level and perhaps other key variables as well. Notably absent from these new models of the liquidity trap, however, is another old idea: that of the real balance effect. First discussed by de Scitovszky (1941), Haberler (1946), and Pigou (1943) and developed most extensively by Patinkin (1965), the real balance effect describes a channel through which a change in real balances, caused either by a change in the nominal money supply or by a change in the nominal price level, impacts household wealth and thereby affects consumption …