If we’re stuck in a liquidity trap, shouldn’t the government massively slash taxes?
Paul Krugman, and others, argue that “the only way for monetary policy to be effective in a liquidity trap was via expectations: the central bank had to convince the public that it would sustain monetary expansion even after the trap was over.”
One problem with this is to figure out how the central bank can effectively convince the public of this. It’s very difficult, especially when you have inflation hawks on the Federal Open Markets Committee threatening to rebel long before there’s any credible signs of inflation .
I would suggest that Federal Reserve cannot actually convince the public that it will sustain monetary expansion. At least, not on its own.
What really makes people worry about inflation is not central bank policy. It’s government borrowing. When government borrowing grows substantially, especially when taxation is constrained, there are fears the central bank will “monetize” the debt.
In order for people to become convinced the Fed will sustain monetary expansion, the government needs to issue a lot more debt. Since increased spending is off the table, the only way to vastly increase government debt would be to cut taxes by a lot.
Notice that I’m not claiming that tax cuts themselves would be especially stimulative. In fact, I think nearly all of it would be used by households and companies to delever—pay down their debts.
What would stimulate would be the debt and attendant inflation fears. You’d basically be punishing people for holding cash.
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