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FWIW I'm not sure that a "credible promise" of inflation would solve the problem either. Unless I misunderstand Krugman, the idea of promising inflation is that individuals shit from savings to consumption/investment thereby curing the shortage of aggregate demand. However the current situation would seem to suggest that analysis to be inaccurate. I think that the majority of people anticipate expect inflation, policy elites and economists aside, so it is arguable that the Fed's QE policy's have provided a credible inflation promise (I suppose if one disagrees with this point the rest of this analysis is moot). In Krugman's analysis individuals should shift consumption from the future into today. We would expect to see the savings rate decline significantly and yet we haven't seen any evidence of this behavior taking place. Another option would be for people to liquidate their savings/retirement holdings to finance incremental consumption today, however individuals may not be able to shift monies set aside for future consumption to today or may not view the two potential sources of funds as fungible. If I'm right, this suggests that the only potential lever to escape a liquidity trap is through fiscal stimulus.
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Sep 27, 2011