Liquidity Traps and Large-Scale Financial Crises

61 Pages Posted: 13 Oct 2016

See all articles by Giovanni Caggiano

Giovanni Caggiano

Department of Economics, Monash University; University of Padua

Efrem Castelnuovo

University of Melbourne - Department of Economics

Olivier Damette

University Paris-Est Créteil (UPEC)

Antoine Parent

Sciences Po Lyon

Giovanni Pellegrino

University of Melbourne - Melbourne Institute of Applied Economic and Social Research

Date Written: October 12, 2016

Abstract

This paper estimates a nonlinear Threshold-VAR to investigate if a Keynesian liquidity trap due to a speculative motive was in place in the U.S. Great Depression and the recent Great Recession. We find clear evidence in favor of a breakdown of the liquidity effect after an unexpected increase in M2 in the 1921-1940 period. This evidence, which is consistent with the Keynesian view on a liquidity trap, is shown to be state contingent. In particular, it emerges only when a speculative regime identified by high realizations of the Dow Jones index is considered. A standard linear framework is shown to be ill-suited to test the hypothesis of a Keynesian liquidity trap. An investigation performed with the same data for the period 1991-2010 confirms the presence of a liquidity trap just in the speculative regime. This last result emerges significantly only when we consider the federal funds rate as the policy instrument and we model the Divisia M2 measure of liquidity.

Keywords: Keynesian Liquidity Trap, Threshold VAR, Monetary and Financial Cliometrics, Great Depression, Great Recession

JEL Classification: B22, C52, E52, N12, N22

Suggested Citation

Caggiano, Giovanni and Castelnuovo, Efrem and Damette, Olivier and Parent, Antoine and Pellegrino, Giovanni, Liquidity Traps and Large-Scale Financial Crises (October 12, 2016). Melbourne Institute Working Paper No. 32/16. Available at SSRN: https://ssrn.com/abstract=2851620 or http://dx.doi.org/10.2139/ssrn.2851620

Giovanni Caggiano

Department of Economics, Monash University ( email )

900 Dandenong Road
Caulfield East, Victoria 3145
Australia

HOME PAGE: http://https://sites.google.com/site/giovannicaggiano72/CV/home

University of Padua ( email )

Via 8 Febbraio, 2
Padova, Vicenza 35122
Italy

Efrem Castelnuovo (Contact Author)

University of Melbourne - Department of Economics ( email )

Melbourne, 3010
Australia

HOME PAGE: http://https://sites.google.com/site/efremcastelnuovo/home

Olivier Damette

University Paris-Est Créteil (UPEC) ( email )

61 avenue du General de Gaulle
Creteil cedex, 94010
France

Antoine Parent

Sciences Po Lyon ( email )

14 avenue Berthelot
Lyon, 69007
France

Giovanni Pellegrino

University of Melbourne - Melbourne Institute of Applied Economic and Social Research ( email )

Level 5, FBE Building, 111 Barry Street
Parkville, Victoria 3010
Australia

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