The Keynesian Liquidity Trap: An Austrian Critique

This paper critiques the Keynesian liquidity trap from an Austrian perspective. The liquidity trap theory argues that at a given interest rate the demand for money is horizontal, and interest rates cannot fall to stimulate investment. The major problem in the theory is that it concentrates on the loan interest rate instead of the price spread in the structure of production, called the natural rate, which as the Austrians have argued is the true interest rate determined by time preferences that the former is only a reflection of. Loan interest rates do not fall because individuals expect the price spread to rise. The rising price spread represents the healthy market correction from a prior boom when interest rates were artificially lowered and must occur for a sustainable recovery. Barring rigid prices from government intervention, which prevent the necessary market adjustments, the liquidity trap does not pose a problem for the free market economy.