The Liquidity Trap

The liquidity trap is a concept which is believed by some economists whereas it is not believed by the others. Many great economists like Keynes, Tobin and Schumpeter have made no mention of the liquidity trap in their works. It was widely believed to be a discredited concept, one that had no application in the real world. Yet, many critics vehemently argue that it is an important concept. Generally, theoretical concepts don’t matter too much. However, the liquidity trap defines exactly the kind of financial situation that the world is in now. It is for this reason that it becomes important to study the concept.

In this article, we will have a closer look at the liquidity trap in order to figure out if it is indeed applicable to the general economic situation of our times.

Definition of Liquidity Trap

In economics, liquidity is defined as the state of having more cash. Hence, the liquidity trap refers to a state where having too much cash circulating in the economy becomes a problem. Cash here does not refer to actual physical cash. Instead, it refers to the aggregate money supply in the market.

For instance, when an economy is not performing as well, governments tend to lower interest rates. This induces consumers to spend their money instead of saving it. This is the reason why each interest rate decline increases the inflow of cash into the market. The lower the interest rates, the higher the money supply.

However, if interest rate declines are successive, the end result is that interest rates reach close to zero. This is the situation wherein the market is already full of cash. In such a situation people start hoarding their cash. They neither want to invest their money nor want to spend it. Investment is not really an option because they are afraid that the interest rates will rise and they will lose value. Spending is also not an option because people are expecting a deflationary situation and hence are saving money for the same.

To put it in simpler terms, a liquidity trap is a situation wherein the central bank loses control of the economy. Even if the central bank lowers the interest rate, people do not behave as per the central bank’s expectations. At the moment, the problem is that the interest rates all over the world are very close to zero. Hence, if there is some kind of recession now, there will be nothing that the central bank will be able to do to control the situation.

Identifying Liquidity Traps

The number one sign of a liquidity trap is near zero interest rates. As mentioned above, very low interest rates do not give the bank the wiggle room required to manage the monetary policy in times of crisis.

Also, when the interest rates are close to zero, the sellers of bonds want to get rid of them. On the other hand, there are no buyers at all. This lack of liquidity in the bond market is another defining feature of the liquidity trap.

Effects of Liquidity Trap

In the events of a liquidity trap, the government wants to somehow induce the people to spend or invest their money. However, it has very few options in order to do so.

  • Increased Interest Rates: The only option that the government has is to sharply increase interest rates. These interest rates start providing better returns to the investors. Once people observe that investing their money in bonds does provide a positive real rate of return, they start buying bonds. This increases the liquidity in the bond market. Even though the prices of bonds fall in the short term, the market once again becomes fully functional.
  • Government Investments: Spending is required in order to stimulate the economy. The liquidity trap threatens to reduce the aggregate demand and throw the economy into a recession. In order to prevent this, the government has to start spending money. The government usually spends money on infrastructure projects. Not only does this simulate the growth of the economy but it also leads to an increase in job creation.
  • Price Cuts: Finally, the government can choose not to interfere for some time. In this situation, there will be a liquidity crunch for some time. However, in the long run, the prices will correct drastically because of a fall in demand. This is when consumers will be forced to spend their money because the real utility that they will derive from these purchases will be higher.

In retrospect, many economists believe that the Great Depression of the 1930’s was a liquidity trap. They believe that the Federal Reserve did not take any action in order to control the recession because there were no possible viable actions that could be taken. The devastating impact of a liquidity trap has, therefore, become well known in economic circles. This is all the more reason to seriously study the impact of this trap and to ensure that it can be avoided in the future.

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Managerial Economics