I have pointed out before that the meaning of the term ‘liquidity trap’ has today become completely altered — with said alteration mainly coming from Paul Krugman’s bizarre redefinition which seems tied up with his idea about a natural rate of interest and the central bank being unable to hit this natural rate due to their coming up against the zero-lower bound.
In actual fact, a liquidity trap occurs when people rush out of assets and instead hold money. This leads to a fall in asset prices and high interest rates which then do not respond to central bank action. We encountered a liquidity trap proper very briefly in late-2008 but due to unprecedented central bank interventions we had exited this liquidity trap by early-2009.
In this post I want to spell out exactly why Keynes thought his liquidity trap idea so important. In order to understand this we must…
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