Monetary Policy in Krugman's Model of a Liquidity Trap
Monetary Policy in Krugman's Model of a Liquidity Trap
In his 1998 article on the liquidity trap, Paul Krugman presents a simple model. This Demonstration shows how monetary policy affects the level of output and the nominal rate of interest in that model. We see that temporarily increasing the money supply (increasing the money supply in the short run, while holding the money supply constant in the long run) increases output. Once the nominal interest rate falls to its zero lower bound, temporarily increasing the money supply does not increase output. Krugman calls this situation a "liquidity trap". In order to increase output in a liquidity trap, the money supply must be increased in both the short run and the long run.