Contact: Corina Boar - firstname.lastname@example.org
Paper Link: "A Neoclassical Theory of Liquidity Traps" by Sebastian Di Tella
Abstract: This paper provides an equilibrium theory of liquidity traps and the real effects of money. In an economy with incomplete risk sharing, money provides a safe store of value that prevents interest rates from falling enough during downturns, creating a persistent slump with depressed investment. This is an equilibrium outcome—prices are flexible, markets clear, and inflation is on target—but it’s not efficient. Investment is too high during booms and too low during liquidity traps. Although money has large real effects, monetary policy is ineffective—the zero lower bound is not binding, money is superneutral, and Ricardian equivalence holds. The optimal allocation requires the Friedman rule and a tax/subsidy on capital.