This Site Requires Javascript
Burger Menu

Liquidity Trap

Definition

A liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers [holding] cash [rather than] holding a debt which yields so low a rate of interest."

Liquidity Trap

The liquidity trap is referred to a situation in which the savings rates are high and the prevailing interest rates are typically low. The central bank tries to decrease the interest rates by injecting money into the private banking system. This makes it impossible for the monetary policy to remain effective. In a condition of liquidity trap, the consumers keep their funds in savings and avoid bonds, because of the general belief that the rates of interest will rise again soon. Since bonds and interest rates share an inverse relationship, therefore, most of the consumers do not want to hold or invest in the assets whose price they expect will decline in the near future.

The Basics of Liquidity Trap

Liquidity trap is one of the most extreme effects of a monetary policy. The general public, who will be under the conditions of liquidity trap, hold on to all the money that is supplied to them, at the rate of interest provided to them. This usually takes place in the cases when they fear the happening of adverse events like war or deflation.

In such cases, there is neither an effect on the level of income of people, nor on the interest rates under open market operations carried out on the monetary policy. The monetary policy, under the liquidity trap, remains powerless to make any changes in the interest rates.

The liquidity trap usually occurs when the interest rate drop to zero percent. In this case, the general public does not want to hold any bonds because money, which is also paying zero percent interest, can at least be used in transactions unlike bonds which will be of no use under such circumstances.

Therefore, if the rate of interest is zero percent, increasing the quantity of money will not play any significant role in the inducing and motivating anyone to buy bonds, thus the interest on bonds fall below the level of zero.


Liquidity Trap FAQ

Why is a liquidity trap bad?

High and low inflation can both be bad for the economy. Therefore, the right monetary policy in a liquidity trap is not to further increase money supply or reduce the interest rate but to raise inflation expectations by raising the nominal interest rate.

What happens during the liquidity trap?

A liquidity trap occurs when monetary policy becomes ineffective because of very low interest rates combined with consumers who would rather save than invest in higher-yielding bonds or other investments.

Is the US in a liquidity trap?

There is proof that the U.S. is in a liquidity trap. The incidence of low interest rates and the ineffectiveness of open-market operations as indicated by continued stagnation proves a liquidity trap. The U.S. experience has been similar to the Japanese's in the 1990s.

Which policy is effective in liquidity trap?

The expansionary fiscal policy is effective.

What causes a liquidity trap?

A liquidity trap occurs when people hoard cash expecting an adverse event such as deflation, insufficient aggregate demand, or war. One of the features of a liquidity trap is interest rates that are close to zero and changes in the money supply that fail to translate into changes in the price level.

How do you get out of a liquidity trap?

There are two ways to escape. The first is using expansionary fiscal policy. The second is lowering the zero nominal interest rate floor. This second option involves paying negative interest on government 'bearer bonds' -- coin and currency, that is 'taxing money', as advocated by Gesell.

What tools are available to a central bank when the economy is in a liquidity trap?

Getting out of a liquidity trap include raising interest rates, and hoping the situation will regulate itself as prices fall to attractive levels, or increased government spending.

Further Reading

Escaping from a liquidity trap and deflation: The foolproof way and othersEscaping from a liquidity trap and deflation: The foolproof way and others
www.aeaweb.org [PDF]
… y Lars EO Svensson is Professor of Economics at Princeton University, Princeton, New Jersey … trap and deflation, how to avoid becoming trapped and how to escape if trapped, often with … in the government debt without stimulating the economy out if its recession and liquidity trap …

Policy options in a liquidity trapPolicy options in a liquidity trap
pubs.aeaweb.org [PDF]
… y Lars EO Svensson is Professor of Economics at Princeton University, Princeton, New Jersey … trap and deflation, how to avoid becoming trapped and how to escape if trapped, often with … in the government debt without stimulating the economy out if its recession and liquidity trap …

Liquidity trap and excessive leverageLiquidity trap and excessive leverage
www.aeaweb.org [PDF]
… y Lars EO Svensson is Professor of Economics at Princeton University, Princeton, New Jersey … trap and deflation, how to avoid becoming trapped and how to escape if trapped, often with … in the government debt without stimulating the economy out if its recession and liquidity trap …

How do financial frictions affect the spending multiplier during a liquidity trap?How do financial frictions affect the spending multiplier during a liquidity trap?
www.sciencedirect.com [PDF]
… y Lars EO Svensson is Professor of Economics at Princeton University, Princeton, New Jersey … trap and deflation, how to avoid becoming trapped and how to escape if trapped, often with … in the government debt without stimulating the economy out if its recession and liquidity trap …

Debt, deleveraging, and the liquidity trap: A Fisher-Minsky-Koo approachDebt, deleveraging, and the liquidity trap: A Fisher-Minsky-Koo approach
academic.oup.com [PDF]
… y Lars EO Svensson is Professor of Economics at Princeton University, Princeton, New Jersey … trap and deflation, how to avoid becoming trapped and how to escape if trapped, often with … in the government debt without stimulating the economy out if its recession and liquidity trap …

Credit crises, precautionary savings, and the liquidity trapCredit crises, precautionary savings, and the liquidity trap
academic.oup.com [PDF]
… y Lars EO Svensson is Professor of Economics at Princeton University, Princeton, New Jersey … trap and deflation, how to avoid becoming trapped and how to escape if trapped, often with … in the government debt without stimulating the economy out if its recession and liquidity trap …

The foreign exchange origins of Japan's economic slump and low interest liquidity trapThe foreign exchange origins of Japan's economic slump and low interest liquidity trap
onlinelibrary.wiley.com [PDF]
… y Lars EO Svensson is Professor of Economics at Princeton University, Princeton, New Jersey … trap and deflation, how to avoid becoming trapped and how to escape if trapped, often with … in the government debt without stimulating the economy out if its recession and liquidity trap …

Is there a fiscal free lunch in a liquidity trap?Is there a fiscal free lunch in a liquidity trap?
academic.oup.com [PDF]
… y Lars EO Svensson is Professor of Economics at Princeton University, Princeton, New Jersey … trap and deflation, how to avoid becoming trapped and how to escape if trapped, often with … in the government debt without stimulating the economy out if its recession and liquidity trap …

Monetary policy in deflation: the liquidity trap in history and practiceMonetary policy in deflation: the liquidity trap in history and practice
www.sciencedirect.com [PDF]
… y Lars EO Svensson is Professor of Economics at Princeton University, Princeton, New Jersey … trap and deflation, how to avoid becoming trapped and how to escape if trapped, often with … in the government debt without stimulating the economy out if its recession and liquidity trap …

Fiscal policy in an expectations-driven liquidity trapFiscal policy in an expectations-driven liquidity trap
academic.oup.com [PDF]
… y Lars EO Svensson is Professor of Economics at Princeton University, Princeton, New Jersey … trap and deflation, how to avoid becoming trapped and how to escape if trapped, often with … in the government debt without stimulating the economy out if its recession and liquidity trap …


Tags

liquidity, trap, interest, monetary, economics, rates, money, rate, policy, situation, economic, cash, financial, economy, finance, traps, people, occurs, definition, supply, bank, demand, central, increase, nominal, krugman, keynesian, investment, hoard, spending, banks, stimulate, paul, fail, high, effect, keynes, savings, united, deflation, adverse, fiscal, implications, markets, recession, model, fall, expansionary, paper, called
Section 508

WCAG 2.0

Section 508