Posted by: Dirk | December 2, 2008

Monetary policy: trapped

Expansionary monetary policy normally works like this: expand the money supply – interest rate falls – investment picks up – employment and output increase. Obviously, this does not work anymore. The bond yield indicates how costly it would be for Baa rated firms to take on new debt. That normally should consist of “the” interest rate (of the Fed) plus a risk premium. Lately, though, interest rates have gone down, but the risk premium has increased so much that monetary policy seems to be unable to influence the interest rate that matters for many firms that find themselves unable to get loans for new investments. If they want any, that is.

The difference between the liquidity trap (increasing money supply does not change the interest rate) and the investment trap (a falling interest rate does not cause an increase in investment) seems gone. If you are in the liquidity trap, how can you possibly know whether you are in the investment trap or not? The only way to find out would be through a change in the interest rate, but this can not happen since we are in the liquidity trap. It’s a sort of Catch 23.

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