Thursday, August 12, 2010

Liquidity Trap Blogging...

On the effects of an oil price shock.

Matt Yglesias worries about the consequences of an Israel-Iran war, and concludes that, if things are bad now, just wait until we've got inflation to worry about! Except, if we have an oil price shock now, we'd be freed from our liquidity trap. This is the counter-intuitive logic whereby everything that is normally "bad" -- i.e., inflationary -- now helps the economy by reducing real interest rates. The only way an oil shock would hurt is if the Fed overreacts, and raises interest rates prematurely to head off inflation before it comes. This is more than a remote possibility, of course, but an oil price shock would at least get us back to the situation where the Fed can simply cut the federal funds rate when it wants to stimulate the economy rather than play word games with the "extended period" language.


  1. So, if i understand correctly, the idea is to have an increase in inflation as a result of a shock because creating inflation expectations or creating inflation the old fashioned way is not in Fed's plans?

  2. Exactly. The Fed right now is the overweight individual who wantsta lose weight, but is unwilling to actually take any action toward that goal. The oil shock here would be like being drafted into the military, where this individual will be subjected to demanding physical training, long jogs and short meals. Of course, said individual could stuff his locker with twinkies, and the training and hunger and stress could make him/her overeat and get fatter, but the most likely scenario is just that s/he'd just lose a lot of weight really quickly.