Liquidity Traps and The Failure of Keynes

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In summary, there are four main schools of economics, namely Keynesian economics, Reaganomics, monetarism, and Austrian economics. These schools have different approaches to stimulating the economy, such as through government expenditure, tax cuts, or the federal reserve system. However, these methods may only have temporary effects and can lead to future issues such as inflation or contraction of the money supply. As a result, there is a dilemma in trying to maintain the money supply and prevent bankruptcies. This is why economics is often referred to as the dismal science, and the traditional solutions are either to do nothing or take random actions in hopes of improvement.
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John Creighto
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The four schools of economics I know of are:
Keynsians economics - which promotes stimulating the economy though government expenditure.
Reaganomics - which promotes stimulating the economy though tax cuts
Monetarism – which promotes stimulating the economy though the federal reserve system. (Often accredited to Milton Friedam even though Friedman was against the federal reserve system)
Austrain Economics – which opposes the Federal reserve system and believes interest rates should be determined by the market. Austrian economists typically believe in the Gold standard.

The two main systems I would like to focus on are Keynsian economics and Reagonmics. Clearly in both cases if spending is increased either by giving people more after tax income or directly though government spending, their will be a stimulus effect. The stimulus works be increasing the amount of money in circulation. Prices will eventually go up to counter act the stimulus and consequently it is only temporary or transient. Thus even if Reagonomics actually worked temporarily, any extra tax revenue would more then be offset by future rises in costs.

In our fait money system the majority of money is actually debt. When you inject more real money into the system you do not always increase the supply of money because sometimes people use this new money to pay down debt (i.e they save). This results in a negative marginal money multiplier.

Since our money is primarily composed of debt then we could consider debt as a proxy for the money supply. The debt would be given by:

[tex]\Delta Debt=- \Delta Savings+\alpha \ Debt[/tex]
where:
[tex]\alpha[/tex] is the bankruptcy rate.

We are faced with a dilemma. In order to maintain the money supply we do not want the debt to contract. If people save most of the new money then the debt will contract and then so will the money supply. So injecting new money into the system could be concretionary. Then again, if we don’t inject new money into the system then the Debt could contract anyway due to bankruptcies.

Consequently, when in a liquidity trap there may be little we can do in the short term to increase the money supply. All we can do is try to reduce bankruptcies snd hope we helped those that should be helped and don’t end up with too much inflation in the long term.
 
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I believe this is why economics is known as the dismal science.
The traditional solutions are to either decide you can't trust economics and do nothing or do anything/something basically at random and hope everything gets better on it's own - or that something like a war happens to distract the public.
 
  • #3
John Creighto said:
The four schools of economics I know of are:
Keynsians economics - which promotes stimulating the economy though government expenditure.
Reaganomics - which promotes stimulating the economy though tax cuts
Monetarism – which promotes stimulating the economy though the federal reserve system. (Often accredited to Milton Friedam even though Friedman was against the federal reserve system)
Austrain Economics – which opposes the Federal reserve system and believes interest rates should be determined by the market. Austrian economists typically believe in the Gold standard.

How many countries in the world execute only one of those models? Lots of thoughs there, through might be the word you are looking for.

mgb_phys said:
I believe this is why economics is known as the dismal science.
The traditional solutions are to either decide you can't trust economics and do nothing or do anything/something basically at random and hope everything gets better on it's own - or that something like a war happens to distract the public.

Obviously you have to try to understand before making such jugdments.
 

1. What is a liquidity trap?

A liquidity trap is a situation in which monetary policy becomes ineffective in stimulating economic growth and inflation. This happens when interest rates are very low and the demand for credit is weak, causing people to hoard cash rather than invest or consume.

2. How does a liquidity trap lead to the failure of Keynesian economics?

In Keynesian economics, it is believed that increasing the money supply through monetary policy can stimulate economic growth and increase inflation. However, in a liquidity trap, this theory does not hold true as people are not willing to borrow or spend even when interest rates are low, rendering monetary policy ineffective.

3. What are the consequences of a liquidity trap?

The consequences of a liquidity trap can include prolonged periods of economic stagnation, deflation, and high unemployment rates. It can also limit the ability of central banks to stimulate the economy through monetary policy, leading to a lack of trust in the effectiveness of government intervention.

4. Can a liquidity trap be avoided?

While a liquidity trap cannot be completely avoided, there are measures that can be taken to reduce its impact. These include implementing fiscal policies, such as government spending and tax cuts, to stimulate demand and encouraging banks to lend by reducing their reserve requirements.

5. How can a liquidity trap be overcome?

To overcome a liquidity trap, policymakers may need to adopt unconventional monetary policies such as quantitative easing, which involves buying government bonds to inject liquidity into the economy. Additionally, structural reforms to increase productivity and consumer confidence can help to boost economic growth and escape the trap.

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