The Liquidity Trap and the Pigou Effect: A Dynamic Analysis with Rational Expectations

23 Pages Posted: 16 Jul 2004

See all articles by Bennett T. McCallum

Bennett T. McCallum

Carnegie Mellon University - David A. Tepper School of Business; National Bureau of Economic Research (NBER)

Date Written: May 1982

Abstract

A Keynesian idea of considerable historical importance is that, in the presence of a liquidity trap, a competitive economy may lack--despite price flexibility--automatic market mechanisms that tend to eliminate excess supplies of labor. The standard classical counterargument, which relies upon the Pigou effect, has typically been conducted in a comparative-static framework. But, as James Tobin has recently emphasized, the more relevant issue concerns the dynamic response (in "real time") of an economy that has been shocked away from full employment. The present paper develops a dynamic analysis, in a rather standard model, under the assumption that expectations are formed rationally. The analysis permits examination of Tobin's suggestion that, because of expectational effects, such an economy could be unstable. Also considered is Martin J. Bailey's conjecture that, in the absence of a stock Pigou effect, Keynesian problems could be eliminated by expectational influences on disposable income.

Suggested Citation

McCallum, Bennett T., The Liquidity Trap and the Pigou Effect: A Dynamic Analysis with Rational Expectations (May 1982). NBER Working Paper No. w0894, Available at SSRN: https://ssrn.com/abstract=301410

Bennett T. McCallum (Contact Author)

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