In the current crisis, the Keynesian response of stimulating aggregate demand through easy money and loose fiscal policy is correct to a point. But flooding the system with excess liquidity that drives short-term interest rates to near zero has been a serious mistake. By the end of 2008, the interest rates on federal funds and short-term Treasury Bills were virtually zero— where they remain today (figure 1). In this liquidity trap, the interbank market remains almost paralyzed so that further Fed injections of liquidity simply led to a buildup of excess reserves in . commercial banks without stimulating new lending.
