David Andolfatto and Tyler Cowen are confused:

In grandma’s liquidity trap, the real interest rate is too high because of the zero lower bound. Steve argues that in our current liquidity trap, the real interest rate is too low, reflecting the huge world appetite for relatively safe assets like U.S. treasuries.

If this latter view is correct, then "corrective" measures like expanding G or increasing the inflation target are not addressing the fundamental economic problem: low real interest rates as the byproduct of real economic/political/financial factors.

My reaction to this is two-fold:

1) Umm…what?
2) OK, here’s how it goes – there are two interest rates at work here, the "true" interest rate, ie, the rate at which people would be willing to invest; and the "prevailing" interest rate, what you’re actually getting in the market. The former reflects the sum of underlying preferences, the latter a mix of the expression of those preferences along with a helping dose of central bank regulation. A liquidity trap is when the former is less than zero. That’s it. What is the difference between the two liquidity traps they discuss? In the former scenario, the prevailing rate cannot be brought below zero to match the true rate, and therefore: liquidity trap. In the latter scenario…the true rate is lower than zero, and the prevailing rate is stuck at zero. Same scenario. In both scenarios, the key is low growth expectations and low inflation expectations means a flight to safe, liquid assets with a low real rate. When the prevailing rate is 5%, and the true rate declines to 3%, then the Fed cuts their rate to 3% and everything is fine. When the true rate goes below zero, though, then the central bank’s ability to guide the economy through the signal of the prevailing interest rate is handicapped and therefore you need something else (debt-financed public spending, QE, NGDPLT, whatever).

I really don’t get this. If I’m missing something, please tell me.

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