# Liquidity Traps and The Failure of Keynes

1. Jan 21, 2009

### John Creighto

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:

$$\Delta Debt=- \Delta Savings+\alpha \ Debt$$
where:
$$\alpha$$ 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.

2. Jan 21, 2009

### mgb_phys

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. Jan 21, 2009

### misgfool

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.

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