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| For the last seven years, most economists agree, the Indian economy has suffered from the problem of deficient aggregate demand. |
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| To stimulate it, the government and the Reserve Bank of India (RBI) started cutting interest rates about three years ago. They thought this would revive investment. But although a mild revival may finally be under way, until now nothing significant has happened. |
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| Meanwhile, the RBI has more or less announced that further cuts in interest rates are unlikely. This is because the real rate of interest which is the difference between the nominal rate and the rate of inflation is already nearly zero. |
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| Any further cut in rates could well lead to what is known as the liquidity trap, a term invented by Keynes to describe a situation when people prefer to hold cash rather than financial assets like bonds, the juicier amongst which are not, in any case, available at the retail level. |
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| Indeed, many well-off Indians would argue that we are already there. After all, given the options before them, where can they put their savings? The stock market is too dodgy. |
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| The returns on debt instruments are too low and no one is guaranteeing returns these days. The real estate market is stagnant, perhaps even falling. Betting on foreign exchange is not allowed. In any case, the rupee is appreciating. Gold remains an option but a tedious one. |
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| In other words, we may well be in a liquidity trap already, inasmuch as people may want to hold on to cash by putting it under their mattresses. |
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| And, when you come to think of it, the Indian situation is only slightly different from the Japanese one. This is the main problem that the government and the RBI have to solve if they want things to start going better. |
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One way out, suggest Alan J Auerbach and Maurice Obstfeld in a recent paper* aimed at Japan but applicable to India as well, is that
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