Paul Krugman wrote:
Brad DeLong points us to David Glasner on John Taylor; I don’t think I need to add to the pile-on. But I do think Glasner misses a point when he says that
the quantity of money, unlike the Fed Funds rate, is not an instrument under the direct control of the Fed.
Actually, under current conditions — in a liquidity trap — it’s not even under the indirect control of the Fed. The same impotence of conventional monetary policy that makes open-market purchases of Treasuries useless at boosting GDP also mean that broad monetary aggregates that include deposits are largely immune to Fed influence. The Fed can stuff the banks full of reserves, but at zero rates those reserves have no incentive to go anywhere, and even if they do they can sit in safes and mattresses……
What liquidity trap is Krugman talking about? In a floating exchange rate currency system liquidity is not constrained. Banks have to get it on demand, otherwise the payment system is going to collapse. And talking about reserves, where can they go in Krugman’s opinion? He writes:
The Fed can stuff the banks full of reserves, but at zero rates those reserves have no incentive to go anywhere, and even if they do they can sit in safes and mattresses.
Lets imagine that fed funds rate target is not close to zero, lets say it is 5%, and now Fed starts doing QE. In order to maintain the target rate Fed has to pay interest on excess reserves. Is Paul Krugman saying that in this case monetary policy is not working because it is liquidity trap? Do now reserves have incentive to go anywhere or do they still sit in matsesses and safes?
I just don’t understand his endless liquidity trap talk and how monetary policy is not working because of it. Would it work in the above mentioned situation?
By the way Paul, IS-LM is based on loanable funds, you might want to check out a recent paper by Bank of England about this.
Almost forgot, Paul Krugman was one the advocates of QE in Japan.