Money, Bonds, and the Liquidity Trap

• Published date: 01 October 2020
• Author: LUIS ARAUJO,LEO FERRARIS
• DOI: http://doi.org/10.1111/jmcb.12697
• Date: 01 October 2020

DOI: 10.1111/jmcb.12697

LUIS ARAUJO

LEO FERRARIS

Money, Bonds, and the Liquidity Trap

This paper examines a search model of money and public bonds in which

coordination frictions lead to multiple, Pareto ranked equilibria. Whether

money and bonds are substitutes or complements, is not a primitive of the

economy, but an equilibrium outcome. There exists an equilibrium resem-

bling a liquidity trap, in which money and bonds are perfect substitutes,

interest rates are zero, and monetary policy is ineffective; and a superior

equilibrium in which money and bonds are complements, interest rates are

positiveand monetary policy has a liquidity effect. On this view, the liquidity

trap is a belief-driven phenomenon.

JEL code: E40

Keywords: money, public bonds, monetary policy, liquidity trap

A     situation in which short-term nominal

interest rates are nil, and remain so despite active policy intervention by the monetary

authorities through open market operations, as money and bonds are treated as perfect

substitutes by traders (see Krugman 1998, Eggertsson 2008). The possibility of a

liquidity trap was rst recognized by Keynes (1936), but its relevance has always

been the object of much skepticism, as it seems to be in conict with the theoretically

solid and empirically sound relationship between the money supply,interest rates, and

prices that underlies the quantity theory of money.1However, the recent experience of

Japan, with its various ineffective attempts to raise interest rates away from the zero

lower bound through monetary expansions; as well as the events following the Great

We thank an Editor and twoanonymous referees for their comments. Remaining errors are ours alone.

L A is at Michigan State University and Sao PauloSchool of Economics-FGV (E-mail:arau-

jolu@msu.edu). L F is at Universita’di Roma, Tor Vergata(E-mail: leo.ferraris@uniroma2.it).

Received July 19, 2019; and accepted in revised form January 23, 2020.

1. According to Lucas (1980), the two central implications of the quantity theory of money, that a

change in the rate of change in the quantity of money induces an equal change in both the rate of ination

and the nominal interest rate “possess a combination of theoretical coherence and empirical verication

shared by no other proposition in monetary economics” (p. 1005). See also Friedman (1970).

Journal of Money, Credit and Banking, Vol. 52, No. 7 (October 2020)

© 2020 The Ohio State University