Liquidity Trap and Fiscal Policy

Liquidity trap: When monetary policy becomes ineffective because, despite zero / very low-interest rates, people want to hold cash rather than spend or buy illiquid assets.


Example: Cut in interest rates in early 2009, failed to revive the economy.

Keynesian argument for fiscal policy in liquidity crisis

Keynesians argue that a liquidity trap means fiscal policy becomes very important for getting an economy out of a recession. Since interest rates are zero but aggregate demand is still falling, governments need to intervene to ‘crowd in’ resources left idle.


The argument is that the rise in private sector saving needs to be offset by a rise in public borrowing. Thus government intervention can make use of the rise in private saving and inject spending into the economy. This government spending increases aggregate demand and leads to higher economic growth

Fiscal policy and crowding out

Monetarists are more critical of fiscal policy. They argue that government borrowing merely shifts resources from the private sector to public sector and doesn’t increase overall economic activity. They argue the increase in government borrowing will push up interest rates and crowd out private sector investment. They point to the experience of Japan in the 1990s where a liquidity trap was not solved by government borrowing and a ballooning public sector debt.

Idle resources and crowding in


This shows the rapid rise in private sector saving in 2008/09.

Keynesians respond by saying, government borrowing may well cause crowding out in normal circumstances. But, in a liquidity trap, the excess rise in savings means that government borrowing won’t crowd out the private sector because the private sector resources are not being invested, but just saved. Resources are effectively idle. By stimulating economic activity the government can encourage the private sector to start investing and spending again (hence the idea of ‘crowding in’)

During great recession (2008-15) Higher debt in the UK led to lower bond yields. There was no crowding out.

Also, Keynesians say that as well as expansionary fiscal policy, it is essential that governments / monetary authorities make a commitment to inflation. If expansionary fiscal policy occurs during periods of deflation it is likely to fail to boost overall aggregate demand. It is only when people expect a period of moderate inflation that real interest rates fall and the fiscal policy will be effective in boosting spending.

Modern Monetary Theory

Modern monetary theory (MMT) argues that in a liquidity trap, the expansionary fiscal policy can be financed by an increase in the money supply and government borrowing is not needed. As long as inflation remains within an acceptable target, the government can print money to finance the spending.


By on October 5th, 2016

2 thoughts on “Liquidity Trap and Fiscal Policy

  1. I’ve taken an interest in economics for forty years, and I’m sick to the back teeth of the Keynes versus monetarist argument. I suggest that when we want to stimulate our economy we go for a policy which involves both Keynsian and monetarist elements, i.e. a budget deficit which is not matched either by increased tax or government borrowing. This constitutes money printing, which is what has happened in 2009 in the guise of “Quantitative easing”.

    This policy is monetarist in that it increases the money supply. It is Keynsian in that it constitutes and injection, very much like an increase in exports. Whether it’s the money supply increase that does the real work or the Keynsian injection – well who cares as long as it works? Conversely, when we want to dampen economic activity with a view to controlling inflation we could (as well as raising interest rates) implement a budget surplus unmatched by tax or borrowing reductions. This equals “money extinguishing”.

  2. Since the clowns who got us into this mess are “still” being rewarded (banks by hoarding reserves and by not being forced into bankruptcy) and the 0% down/no doc homeowners (who are allowed to stay in their homes without paying anything for up to 3 years), we have stagnation. Because banks are not releasing (or are slowly releasing) houses back onto the market, prices are being propped up artificially. This benefits the banks who don’t have to mark to market, and the homeowners.

    Helloooooo!!!! How about trying something different. How about rewarding the people who didn’t take ridiculous risks because they knew the bubble was going to burst eventually? Why not raise interest rates for the savers (who didn’t partake in the merriment). This would force the homeowners out (who shouldn’t ever have been there in the first place), and would force the banks who took ridiculous risks out, making room for new banks who are fiscally prudent to come in.

    The savers, after receiving interest on their money, would begin to feel safer, and would begin to invest their hard-saved money.

    You’re trying to help the wrong people. The ones who would invest wisely are the savers (the ones who are being penalized right now).

    The idiots need to be weeded out. If you want a flower to grow, get rid of the weeds.

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