Monetary Policy in a Liquidity Trap

Michael Dotsey

Emeritus Economist

Q2 2010

Business Review — In the United States, the Federal Reserve sets monetary policy by targeting the federal funds rate. This process usually involves lowering short-term interest rates when economic growth is weak and raising them when economic growth is strong.

A wide class of economic models has shown that, in theory, conducting policy in this way allows the economy to employ resources efficiently. In addition, many empirical studies have shown that most central banks actually behave in this manner. In normal times, it is fairly easy for the central bank to conduct policy in this fashion. But there is one instance when conducting policy in this manner becomes problematic: when the economy finds itself in a “liquidity trap,” a situation in which the short-term nominal interest rate is zero or very close to zero. In this article, Mike Dotsey analyzes the difficulties a central bank faces in such circumstances and discusses the tools available to monetary policymakers. Policy as usual is not an option, and the central bank’s framework for conducting policy must change.

This article appeared in the Second Quarter 2010 edition of Business Review.

View the Full Article