Research Highlights Featured Chart

December 10, 2025

Understanding liquidity traps

Lessons from Roosevelt's monetary policy changes and the end of the Great Depression.

Tyler Smith

Source: Franklin Delano Roosevelt Presidential Library

When the economy weakens, central banks respond by lowering interest rates to encourage borrowing and spending. But recent large downturns, such as the Great Recession and Japan’s Long Recession, have highlighted a major limitation of this tool—the zero lower bound. In such extreme circumstances, the economy can get stuck in what economists call a liquidity trap.

In a paper in the Journal of Economic Literature, authors Gauti B. Eggertsson and Sergei K. Egiev offer a unified theoretical framework for understanding liquidity traps. The authors argue that for fast-moving forces that quickly drive interest rates down, such as banking crises, government budgets and public expectations play a key role. They examine these forces in the largest economic downturn in US history—the Great Depression. 

Figure 29 from the authors’ paper provides a snapshot of the wild price and output swings experienced in the United States from 1926 to 1942.

Figure 29 from Eggertsson and Egiev (2025)

The chart plots the Wholesale Price Index (right axis) and Industrial Production (left axis). Both indices collapsed dramatically between 1929 and 1933, with industrial production falling by roughly 50 percent, and wholesale prices declining by approximately 40 percent. However, both series reversed course abruptly in March 1933, when Franklin D. Roosevelt assumed the presidency.

Eggertsson and Egiev contend that FDR implemented what they call a "regime change" by abandoning the gold standard and the commitment to balanced budgets that had constrained the Hoover administration. This policy shift dramatically altered expectations about future inflation. When businesses and households came to believe that prices would rise rather than continue to fall, they increased spending, generating a self-fulfilling recovery.

However, after industrial production returned to pre-Depression levels in 1937, the recovery stalled. The administration weakened its commitment to reflating prices back to 1926 levels, the Federal Reserve raised reserve requirements, and Congress attempted to balance the budget. Markets interpreted these actions as a reversal to the pre-Roosevelt policy regime, and industrial production experienced the sharpest contraction in American history. The subsequent recovery in 1938 occurred when the administration recommitted to its inflationary objectives. 

This pattern of regime change, policy reversal, and renewed commitment provides support for the proposition that fiscal policy paired with credible management of expectations are essential tools when interest rates have hit the zero bound.