Liquidity Traps: A Unified Theory of the Great Depression and the Great Recession

Eggertsson, Gauti B.; Egiev, Sergey K.

doi:10.1257/jel.20241306

Abstract

This review of liquidity traps unifies three landmark economic downturns鈥攖he US Great Depression, the Great Recession, and Japan鈥檚 Long Recession鈥攊nto a single analytical framework. We examine various forces that drive natural interest rates negative: temporarily (such as banking crises and debt overhangs) or permanently (such as demographic shifts and inequality). When policy rates hit the zero lower bound, conventional monetary tools lose traction. Under a standard monetary policy regime, counterintuitive paradoxes emerge: Greater price flexibility deepens recessions, and positive supply shocks become contractionary. We show how policy effects鈥攊ncluding the size of fiscal multipliers, forward guidance, and these paradoxes鈥攄epend critically on the monetary-fiscal regime and on central-bank credibility. The paper explains how regime changes, such as Roosevelt鈥檚 1933 abandonment of the gold standard and balanced-budget dogmas, successfully reversed deep slumps by credibly shifting expectations. We examine whether secular-stagnation forces are likely to assert themselves in the coming decades.

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Journal of Economic Literature