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The Liquidity Trap

Article in Econometrica · February 1976

DOI: 10.2307/1911386 · Source: RePEc

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The Liquidity Trap
Author(s): Jean-Michel Grandmont and Guy Laroque
Source: Econometrica, Vol. 44, No. 1 (Jan., 1976), pp. 129-135
Published by: The Econometric Society
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 Econometrica,Vol. 44, No. 1 (January 1976)

THE LIQUIDITY TRAP

BY JEAN-MICHEL GRANDMONT AND GuY LAROQUE1

If the liquidity trap is viewed as a property of the aggregate demand for money (or liquid
assets), it can be generated from the agents' microeconomic behavior only in special cases,
even in the presence of the Keynesian assumption of inelastic expectations. On the other
hand, in an economy where a central bank intervenes by open market operations, short
run equilibriuminterest rates on long term bonds tending to zero are associated with short
run equilibriummoney stocks which tend to infinity, once the Keynesian assumption of in-
elastic expectations is made.

ACCORDINGTO KEYNESIANthinking, the power of monetary policy to stimulate

economic activity by driving down interest rates may be impaired by the occur-
rence of a "liquidity trap." Usually this name is given to a special property of the
demandfor money, which is supposed to increase without limit as the long term
rate of interest falls to zero. Some economists even claim that this liquidity trap
can appear when the rate approaches some low but positive level. This pheno-
menon is rationalized by postulating that interest rates expectations are inelastic.
Then when the long term rate is low enough, prices of bonds are expected to fall
so that, in Keynes' words [6, Ch. 15], "almost everybody prefers cash to holding
a debt which yields so low a rate of interest." This argument has been criticized
from a purely logical point of view, for it is restricted to a binary choice between
money and long term bonds. As a result, some economists have come to think
that the "liquidity trap," considered as a property of the demand for money, is
conceptually but a limiting case.
We wish to shed some light on the issue by using a microeconomic general
equilibrium model. We shall show indeed that, if the liquidity trap is viewed as a
property of the demand for money (or liquid assets), it can be generated from the
agents' microeconomic behavior only in special cases, even in the presence of the
Keynesian assumption of inelastic expectations. But we shall prove a general
property of the trade-off between the short r'un equilibrium rate of interest on
long term bonds and the short run equilibrium money stock, in an economy
where a central bank intervenes by open market operations. Specifically, equilib-
rium interest rates on long term bonds which tend to zero are associated with
equilibriummoney stocks which tend to infinity, once the assumption of inelastic
price expectations is made.2
The purpose of this paper is to make precise these heuristic statements. This
goal will be achieved by studying a modified version of a model presented else-
where by the authors [2, 3]. A brief description of the model and the statements
of the results are given in Section 1. Proofs are gathered in Section 2.

IWe greatly benefited from conversations with A. P. Kirman.

2
That such a statement might be true was conjectured by Patinkin [8, Ch. 14:3]. For a different
approach to the problem in a general equilibrium framework, see Younes [9].

129

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130 J.-M. GRANDMONT AND G. LAROQUE

1. FORMULATION AND RESULTS

We consider a closed exchange economy which consists of I traders indicated

by i = 1.. I, and a central bank that issues fiat money by open market purchases
or sales on long term bonds. There are I perishable consumnptiongoods available
in each period. On the other hand, traders can hold (at no cost) as a store of value
n perfectly durable goods which-to simplify-yield no direct services to them.
The traders also can hold two monetary assets: money and long term liabilities
of the bank, called bonds. A unit of bond is a promise made by the bank to pay
the bearer one unit of money in every period.
Spot markets for consumption and durable goods, money and bonds are
organized in each period. In the sequel, a trader's action in every period will be
described by x = (q, z) e R' nl+2 = X, where q E R' is the trader's consumption,
and z = (k, b, m) represents his holdings of assets, that is, his stocks of durable
goods k E R +, a stock of bonds b E R + and his cash balance m E R +. Monetary
prices will be described by ir = (p, s) where p E R'+ stands for prices of consump-
tion goods while s e Rn++2represents prices of assets. The price of money Sn+ 2 iS
equal to I; the price of bonds Sn+ 1 defines the long term interest rate r = 1/sn+ 1
For the sake of convenience, we shall work with strictly positive price systems
(r >>0).' Let P be the set of 7r = (p, s) E X such that ir >> 0, S,?+2 = 1
Look at the economy at time t. The ith trader starts with an endowment ei(t) =
(wi(t),zi(t - 1)), where wv(t)E R'+ is his endowment of consumption goods (which
as in Patikin's world he received or produced at the beginning of the period) and
zi(t - 1)E Rn+2 describes the stocks of assets that he carried over from the previous
period. We shall make the following assumption:

1: Xi ei(t) >>0.
ASSUMPTION

Each consumer makes plans only for the current and the next periods. This
assumption is made for notational convenience: our analysis applies as well to
the case of a longer planning horizon. The ith trader must therefore forecast his
endowment of consumption goods and the price system which will prevail at
time t + 1. For notational convenience, we assume that he expects with certainty
an endowment wi(t + 1) E R'+ of consumption goods. His price forecast explicitly
depends on the current price system4 ir(t)e P, and is a probability measure
Vj(7r(t))defined on P. Let M(P) be the space of all these measures, endowed with
the topology of weak convergence of probability measures [see 7, Ch. 2]. We
shall make the following assumptions:

ASSUMPTION 2.1: For all i, the mappingOi: P -* M(P) is continuoals.

3 The following notation is used. For any x, y in R', x > y means Xh > Yh, all h, while x > y means
x > y, x i y. Finally, x >>y means Xh > Yh. all h.
4 The traders' expectations implicitly depend upon his information on the past: past prices systems.
stocks of money and bonds, and so on.

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 LIQUIDITY TRAP 131

ASSUMPTION 2.2: For all i, the image of P by /i is contained in a compact subset

of M(P).

The second assumption makes precise in this model the Keynesian condition
of -inelastic expectations. It is satisfied if the family of probability measures
Joi(n)1r cEP} is tight, that is, if for every e > 0, there is a compact subset C, of P
such that i(, CE) 1 - E for all ic in P [7, Ch. 2, Theorem 6.7]: This implies in
particular that the trader's subjective probability of making a loss by holding a
bond tends to one when the long term interest rate falls to zero.
The ith consumer's preferences at time t are described by a complete pre-
ordering -i defined on M(Q), where Q = R' x R+ is the space of feasible con-
sumption streams for the current and next periods, while M(Q) is the space of
probability measures defined on Q. We postulate the expected utility hypothesis
as follows:

POSTULATE 1: For every i, there exists a bounded, continuous utility function

ui: Q R
-+ such that the function vi :M(Q) -+ R defined by vi(i) fSQ ui dA,AE M(Q)
is a representationof > i. Thefunction ui is assumedto be concave,strictly increasing.

Given ir(t) in P, the ith trader has to choose a strategy, that is, an action x =
(q1, z) E X with z = (k, b, m) in the current period and a random variable q2(*)
into (R' , B(R' )) subject to the follow-
from the probability space (P, B(P), fi(nr(t)))
ing budget constraints: S

(i) 7c(t)- x = rc(t). ei(t) + bi(t - 1),

(ii) p - q2(m)= p W(t + 1) + sz + b, for all r = (p, s) E P.

(In these constraints, the trader's wealth in each period is the sum of his nominal
income (the value of his endowment of consumption goods) plus the value of his
assets, plus the interest payments made by the bank.) Each such strategy induces a
probability distribution on Q, i.e., an element of M(Q). The trader will look for
strategies which maximize his preferences -j, subject to (i) and (ii). To the set
of optimal strategies corresponds a set of optimal actions Qi(7U(t)).
The bank's only activities at time t are open market purchases or sales of bonds
and interest payments. They are thus described by a vector y = (q, k, b, m) e R`++2
where q = 0 (k = 0) represents the bank's net supply of consumption goods
(durables), while b and m are the bank's net supply of bonds and money, respec-
tively. Given 7r(t) = (p(t),s(t)) e P, hence the interest rate r(t) = 1/sn+ 1(t) > 0,
b and m must be related by the accounting identity

(1) mm= -(b/r(t)) + Zbi(t - 1)

For any x, y in R', x *y means Ih XhYh.

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132 J.-M. GRANDMONT AND G. LAROQUE

which expresses the fact that the net supply of money is equal to the issue of money
by open market purchases plus interest payments on outstanding bonds. Let
Y(71(t))be the set of y = (q, k, b, m) such that q = k = 0 and (b, m) are related by
(1). A monetary policy is defined by the bank's supply correspondence 1j which
associates to any 7r(t)in P a (may be empty) subset of Y(7r(t)).
A temporary equilibrium at time t corresponding to a monetary policy 1j is
described by a price system 7r(t)E P, I actions xi(t), and a bank's activity y(t) such
that:
xi(t) E dj(n(t)) for all i,
Y(t) G 11(7E(t)),
and
Zxi(t) = y(t) + E ei(t).
Now assume that the bank wishes to fix the interest rate at an arbitrary level
r > 0. The associated monetary policy ilr is defined by "ir(j(t)) is equal to Y(iR(t))
for all 7r(t)= (p(t),s(t)) in P which satisfy s,n,1(t) = 1/r, and to the empty set
otherwise."

THEOREM1: Fix an arbitrary rate of interest r > 0. There exists a temporary

equilibriumcorrespondingto the monetary policy Cr,

This result shows that the bank can drive down the interest rate as low as it
wants by pursuing an appropriate open market policy (compare with [8, Ch. 14:
3]).
What about the "liquidity trap"? We wish to show that it cannot be interpreted
as a general property of the trader's demand for money, even in the presence of the
Keynesian assumption of inelastic expectations (Assumption 2.2).
We must consider the statement "the demand for money may tend to infinity
when the rate of interest goes to zero." Such a statement, however, is meaningless
if one does not specify the behavior of current prices of consumption goods and
of durables.One mustthereforelook at a sequence7it(t) E P suchthat lim si + l(t) =
+ oo. It is plain from our discussion of Assumption 2.2 that the traders will
eventually become sellers of bonds when j is large enough. The money value of
the traders' sales of bonds is likely to increase without limit. But one cannot in
general claim that the trader's demand for money itself grows indefinitely, for the
traders may choose to buy durable goods or to increase their current consump-
tion rather than to hold increasing cash balances.
As a matter of fact, it is easy to construct nonpathological examples of sequences
7it(t) such that the corresponding demands for money are zero for all j. Look at a
typical consumer, and assume that his price forecast is certain and independent
of 7t(t), so that Assumption 2.2 is obviously satisfied. Let this price forecast be
7Ce(t+ 1) = (pe(t + 1), se(t + 1)) E P. Consider a sequence 7i(t) = (pi(t),si(t)) in P
such that sn+ l(t) tends to + oo. Trivially, the associated demands for money must

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 LIQUIDITY TRAP 133

be zero for all j if the price of some durable good is expected to rise, i.e., if there is
an index 1 i h i n such that si(t) < s'(t + 1) for all j. The argument for consump-
tion goods is a bit more involved. Assume for the sake of simplicity that there is
only one consumption good (1 = 1), and fix j. The consumer's problem is to
maximize u(q1, q2) subject to
(i) 7rc(t)-x =7rcj(t)- e(t) + b(t - 1),
(ii) pe(t + 1)q2 = pe(t + 1)w(t + 1) + Se(t + 1) z + b,
where x = (q1, z), z = (k, b, m), and q2 are unknown. Now assume that u is dif-
ferentiable and that the marginal rate of substitution (au/aq2)/(au/aq1) is uniformly
bounded above by / > 0. Assume that w(t + 1) > 0, too. Then if/pi(t) < pe(t + 1),
the trader's demand for money must be zero.6
These examples are admittedly extreme. But they show that any statement like
"for a sequence 7it(t) E P satisfying lim s + 1(t) = + oo, the corresponding demand
for money grows without bound" involves implicit and quite restrictive assump-
tions on the behavior of the sequence 7ti(t).
Things are much simpler if we interpret the liquidity trap as a property of the
trade-off between the equilibrium long term interest rate and the equilibrium
money stock that is implied by the above theorem.7 For any rate of interest r > 0,
let p(r) be the set of all equilibrium total money stocks that the traders hold at the
corresponding tem'poraryequilibrium.

PROPOSITION 1 (The Liquidity Trap): For any sequence ri which tends to zero,
and any sequence Mi E y(rJ),one has lim MJ = + oo.

The economic mechanism leading to this phenomenon is easy to understand.

Since expectations are inelastic (Assumption 2.2), the traders should be net sellers
of bonds when the rate of interest is close to zero. Thus as the rate falls to zero,
the bank must create increasing amounts of money to bring the bond market into
equilibrium.
2. PROOFS
The following have been shown elsewhere (see [2] which can be easily adapted):
(2.1) For every 7r(t)E P, Qi(7r(t))
is non empty,compact,convex. The correspondence
i: P -+ X is upper hemi-continuous.8
(2.2) Consider a sequence 7cj e P which either tends to 7t e P\P or is such that
lim jlijj1= + oo. Thenfor any sequence xJ E 4(nJ),one has lim IIx'lI= + oo.
6 First, remark that equalities in constraints (i) and (ii) can be replaced by inequalities A. Apply the
Kuhn-Tucker theorem [5, Theorem 7.1.2] and let A, and A2 be the dual variables of (i) and (ii). It
suffices to show that A, > A2. But A, > (Ou/aq1)/p(t).Further w(t + 1) > 0 implies that the optimal
solution satisfies q2 > 0. Thus A2 = (au/aq2)/pe(t + 1) and the result follows.
7 This trade-off depends on past states of the economy. It depends on the zi(t - 1) through the
traders' budget constraints. It also depends upon past states by their influence on the traders' expecta-
tions i/.
8 A correspondence 4 from a metric space X into a metric space Y is upper hemi-continuous (u.h.c.)
if for every open subset G of Y, the set {x E XI4(x) c G} is open in X.

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134 J.-M. GRANDMONT AND G. LAROQUE

For a discussion of the importance of a condition like Assumption 2.2 for the
validity of (2.2) and thus the existence of a temporary equilibrium, see [2].

PROOF OF THE THEOREM: The proof is only a slight modification of the argument
used to prove [3, Theorem 5.1]. Fix r > 0 and consider P7 = {it = (p, s) E PIsn+ =
r}. For any 7t = (p, s) e Pr, let g be the element of R' In, 1 obtained by dropping the
(n + l)th component of s. Let G c R' 1 be the set obtained in that way. Now
let g E G and consider the associated 7t E Pr. Let xi = (qi, ki, bi, mi)E Qi(t) for all i,
and look at the unique y = (0, 0, b,M) eCt1r(7) such that b = Xi (bi - bi(t - 1)).
Define the vector z E R+n+1 as (Xi(qi - qi(t - 1)),Xi(ki - ki(t - 1)), -m + Xi(mi-
mi(t - 1))).Let ;(g) be the set of such z when the xi's vary in Qi(t). We have to find
g* E G such that 0 E '(g*).
But, from (2.1) and (2.2), satisfies all conditions of a known theorem (see, e.g.,
[2, Theorem 1 of the Appendix]). Thus there exist g* E G and z* E 4(g*) such that
z* O. 0 This implies, in view of g* >>0 and g* z* = 0, that z* = 0. Q.E.D.

PROOF OF THE PROPOSITION: Assume the contrary. That means that we can find
a subsequence (keep the same notation) ri and M' E ,4(rl) such that r' tends to zero
and Mi is bounded. Now consider the corresponding equilibria (mi,(xl), yi), and
let xi = (qJ,
q ki, bi, min) = xJ. We have .qJ = Yi qi(t - 1), ki = Yj ki(t - 1) and
mi = Mi, while, from the accounting identity of the bank's operations,
Mi = -(bi - bi(t - 1))/ri + , bi(t - 1).

It follows that the sequence xi is bounded. But xi E 4(7it), a contradiction to (2.2).

Q.E.D.
3. CONCLUSION

We have shown the existence of a liquidity trap in our model when price expecta-
tions are inelastic, when the concept of a liquidity trap is understood as a property
of the trade-off between the short run equilibrium interest rate on long term bonds
and the short i An equilibrium money stock. This phenomenon arises because
when the equilibrium interest rate is low, the central bank must create large
amounts of money in order to bring the bond market into equilibrium. We conjec-
ture that this kind of phenomenon is likely to be present in many reasonable
general equilibrium models.9 The concept of a liquidity trap may of course have to
be slightly modified, in view of the model at hand. For instance, if the bank also
issues short term assets yielding a positive interest in addition to money and
perpetuities, the trade-off to be considered sh'ould be between the equilibrium
long term interest rate and equilibrium liquid assets (money + short term assets).
This is due to the possibility that the money created by the banks' purchases of
long term bonds when the long term interest is low may be partially or completely

' But the strength of this phenomenon, hence its practical relevance, may be very small.

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 LIQUIDITY TRAP 135

wiped out by compensating open market sales of short term assets by the bank.'0

C.O.R.E., Universite Catholique de Louvain, Belgium,

and
E.N.S.A.E., Paris, France
Manuscript received March, 1974; revision received December, 1974.

REFERENCES
[1] DEBREU, G.: Theory of Value. New York: Wiley, 1959.
[2] GRANDMONT,J. M.: "On the Short Run Equilibrium in a Monetary Economy" in Allocation
under Uncertainty, Equilibriumand Optimality, ed. by J. Dreze. New York: Macmillan, 1974.
[3] GRANDMONT,J. M., AND G. LAROQUE:"On Money and Banking," Review of Economic Studies,
42 (1975), 207-237.
[4] HALMOS,P. R.: Measure Theory. New York: Van Nostrand, 1950.
[5] KARLIN, S.: Mathematical Methods and Theory in Games, Programmingand Economics. Reading,
Mass.: Addison-Wesley, 1959.
[6] KEYNES, J. M.: The General Theory of Employment, Interest and Money. New York: Harcourt,
Brace and Co., 1936.
[71 PARTHASARATHY, K. R.: Probability Measures on Metric Spaces. New York: Academic Press, 1967.
[8] PATINKIN,D.: Money, Interest and Prices, 2nd ed. New York: Harper and Row, 1965.
[9] YOUNES,Y.: "Interet et Monnaie Extemnedans une Economie d'Echanges au Comptant en Equilibre
Walrasien de Court Terme," CEPREMAP, 1972. English version, 1973.

1' Note that, in this example, the bank has a new degree of freedom since it can also choose the
short-term interest rate. It must be emphasized that the main difficulty in the process of precisely
formulating such a model would be to explain why money is held in the presence of a short-term
default-free asset that yields a positive interest. This would make necessary the explicit introduction
of the function of money as a medium of exchange.

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