Liquidity Trap Explained

A liquidity trap occurs when low / zero interest rates fail to stimulate consumer spending and monetary policy becomes ineffective. In this situation, even an increase in the money supply could fail to increase spending because interest rates can't fall further.

A liquidity trap means consumers' preference for liquid assets (cash) is greater than the rate at which the quantity of money is growing. So any attempt by policymakers to get individuals to hold non-liquid assets in the form of consumption by increasing the money supply won't work.

For a long time, the macro-economy was managed by changing interest rates. So it is quite a shock for policy makers to experience a situation where their main policy tool was no longer sufficient. Hence the range of unorthodox monetary and fiscal policies.

Liquidity Trap 2009

Base interest rates were cut to 0.5% in March 2009. For a considerable time, the economy remained in recession. Technically, the economy is now creeping back to positive growth, but, the economy remains sluggish. So 2009, has been a good example of a liquidity trap.

Why do Liquidity Traps Occur?

  • Expectations of deflation. If there is deflation or people expect deflation (fall in prices) then real interest rates can be quite high even if nominal interest rates are zero. - If prices are falling 2% a year, then keeping cash under your mattress means your money will increase in value. The difficulty is in having a negative nominal interest rates (banks would be paying you to borrow money). There have been attempts to create a negative interest rates (e.g. destroy money in circulation but in practise it is rarely implemented.
  • Preference for Saving . Liquidity traps occur during periods of recessions and a gloomy economic outlook. Consumers, firms and banks are pessimistic about the future, so they look to increase their precautionary savings and it is difficult to get them to spend. This rise in the savings ratio means spending falls. Also, in recessions banks are much more reluctant to lend. Also, cutting the base rate to 0% may not translate into lower commercial bank lending rates as banks just don't want to lend.
  • Credit Crunch. Banks lost significant sums of money in buying subprime debt which defaulted. Therefore, they are seeking to improve their balance sheets. They are reluctant to lend so even if firms and consumers want to take advantage of low interest rates, banks won't lend them the money.
  • Unwillingness to hold bonds. If interest rates are zero, investors will expect interest rates to rise sometime. If interest rates rise, the price of bonds falls (see: inverse relationship between bond yields and bond prices) Therefore, investors would rather keep cash savings than hold bonds.
Related

Tomorrow
  • Overcoming a liquidity trap
Perma Link | By: T Pettinger | Monday, October 5, 2009
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