12. Financial Crisis and Liquidity Trap Some Theoretical and Policy Perspectives

Perhaps, the most notable feature of the ongoing global financial and economic crisis is the prevalence of near-zero interest rates along with persistence of large, often-growing, unemployment over the last 5 years in practically all advanced countries. Such a situation figures as a theoretical curiosum in the old-fashioned Keynesian theory, but has been conspicuous by its absence in the mainstream macro economic paradigm ruling since the mid 1970s—a paradigm that constitutes a synthesis between the new classical and new Keynesian economics. However, since both the economic travails of Japan during the last two decades and the ongoing crisis have highlighted how intractable the trap generally is, it is worthwhile to go into the analytics of the phenomenon and examine the efficacy of alternative policy instruments for escaping from the trap. Accordingly, we recapitulate the Keynesian theory of the liquidity trap, indicate the nature of its modern incarnation and briefly note its implications for the macro economy. As a prelude to a more fruitful discussion of the subject, we take stock of some stylized facts associated with some major episodes of the trap. This paves the way for identifying its main sources and drawing some policy conclusions.