Five Nominations for the Best Weblog Post Ever!
Angry Bear Is... Angry!

Paul Krugman Is Right!

Alex Tabbarrok writes:

Marginal Revolution: Assorted Links: The Impact of Milton Friedman on Modern Monetary Economics.  A nice review by Edward Nelson and Anna Schwartz of Friedman's thought and influence over monetary policy that also, in the author's words, sets the record straight on Paul Krugman's 'Who was Milton Friedman'...

I tend to be on Paul's side of this--especially on the issue of the 'liquidity trap'. In a liquidity trap, (a) short-term interest rates are essentially zero and (b) banks have excess reserves. Normally the Federal Reserve changes people's behavior by trading short-term government bonds (which pay interest) for bank reserves (which allow banks to expand their deposits and loans). Fewer government bonds in the economy means more appetite by banks to buy corporate bonds and thus to finance corporate investment. More bank reserves means banks have more freedom to make direct loans as well.

But in a liquidity trap bonds pay no interests, and banks have more than enough reserves to cover their lending to all the borrowers they think are credit worthy. So when the Federal Reserve swaps government bonds for bank reserves it is swapping two assets that are equivalent. Why should this change anybody's behavior? The only reason is that banks think that they might be short of reserves and want more at some unknown point in the future, but can this have a big impact on the economy?

I would say no: that Paul Krugman's approach to the liquidity trap is right.