The Liquidity Trap, the Great Depression, and Unconventional Policy: Reading Keynes at the Zero Lower Bound

80 Pages Posted: 22 Nov 2014

See all articles by Richard C. Sutch

Richard C. Sutch

University of California, Riverside and Berkeley; University of California, Berkeley; National Bureau of Economic Research (NBER)

Date Written: November 21, 2014


The developed economies of Japan, the United States, and the Eurozone are currently experiencing very low short-term rates, so low that they are considered to be at the “zero lower bound” of possibility. This effectively paralyzes conventional monetary policy. As a consequence, monetary authorities have turned to unconventional and controversial policies such as “Quantitative Easing,” “Maturity Extension,” and “Low for Long Forward Guidance.” John Maynard Keynes in The General Theory offered a rich analysis of the problems that appear at the zero lower bound and advocated the very same unconventional policies that are now being pursued. Keynes’s comments on these issues are rarely mentioned in the current discussions because the subsequent simplifications and the bowdlerization of his model obliterated this detail. It was only later that his characterization of a lower bound to interest rates would be dubbed a “Liquidity Trap.” This essay employs Keynes’s analysis to retell the economic history of the Great Depression in the United States. Keynes’s rationale for unconventional policies and his expectations of their effect remain surprisingly relevant today. I suggest that in both the Depression and the Great Recession the primary impact on interest rates was produced by lowering expectations about the future path of rates rather than by changing the risk premiums that attach to yields of different maturities. The long sustained period when short term rates were at the lower bound convinced investors that rates were likely to remain near zero for several more years. In both cases the treatment proved to be very slow to produce a significant response, requiring a sustained zero-rate policy for four years or longer.

Keywords: liquidity trap, quantitative easing, zero lower bound, Great Depression, monetary policy, term structure, John Maynard Keynes

JEL Classification: B22, B03, E43, E52, G11, G18, N10

Suggested Citation

Sutch, Richard C., The Liquidity Trap, the Great Depression, and Unconventional Policy: Reading Keynes at the Zero Lower Bound (November 21, 2014). Available at SSRN: or

Richard C. Sutch (Contact Author)

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