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A Neoclassical Theory of Liquidity Traps -- by Sebastian Di Tella

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This paper provides an equilibrium theory of liquidity traps and the real effects of money. Money provides a safe store of value that prevents interest rates from falling enough during downturns, and the economy enters a persistent slump with depressed investment. This is an equilibrium outcome--prices are flexible, markets clear, and inflation is on target--but it's not efficient. Investment is too high during booms and too low during liquidity traps. Although money has large real effects, monetary policy is ineffective--the zero lower bound is not binding, money is superneutral, and Ricardian equivalence holds. The optimal allocation requires the Friedman rule and a tax/subsidy on capital.

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