Liquidity trap

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The term liquidity trap is used in macroeconomics to refer to a situation where a country's nominal interest rate has been lowered nearly to or equal to zero to avoid a recession, but the liquidity in the market created by these low interest rates does not stimulate the economy to full employment. In this situation, any further increase in the money supply will not stimulate the economy any further. This is because any further injection of liquidity will no longer lower the nominal interest rate, as the nominal interest rate cannot drop below zero. This situation can lead to price deflation, which, according to many schools of economic thought, will make a recession even more severe.^[1]

Contents 1 Theory 2 Different perspectives 3 Japan's liquidity trap 4 See also 5 Notes 6 References

[edit] Theory

In normal times, the monetary authority (usually a central bank or finance ministry) can stimulate the economy by increasing the liquidity available in the financial system. This is done by lowering interest rate targets or increasing the monetary base. These actions are meant to increase borrowing and lending, consumption, and fixed investment. However, since cash implicitly pays an interest rate of 0%, the nominal interest rate in the financial system is bounded at zero. When the relevant interest rate is already at or near zero, if the economy enters a recession, lowering interest rates to a level which would adequately stimulate the economy may no longer be possible. The monetary authority can increase the overall quantity of money available to the economy, but traditional monetary policy tools do not inject new money directly into the real economy. Rather, the new liquidity created must be injected into the real economy by way of financial intermediaries such as banks. In a liquidity trap, banks are unwilling to lend, so the central bank's newly-created liquidity is trapped behind unwilling lenders.

The theory of liquidity traps applies to monetary policy in non-inflationary depressions. The theory does not apply to fiscal policies. Hence, in the situation of a liquidity trap, fiscal policies applied by the government may still be able to stimulate the economy enough to bring it out of recession.^[2]

[edit] Different perspectives

Milton Friedman suggested that a monetary authority can escape a liquidity trap by bypassing financial intermediaries to give money directly to consumers or businesses. This is referred to as a money gift or as helicopter money. The term helicopter money is meant to portray the image of a central banker dropping money on people from a helicopter.^[3] As with all government actions politics and professional preferences will affect where liquidity is injected into the economy.

John Maynard Keynes is usually seen as the inventor of the liquidity-trap theory. In his view, financial actors fear the possibility of suffering capital losses on non-money assets and thus hold money (liquid assets) instead. For example, the fear of default on loans can inhibit lenders from lending except to extremely credit-worthy customers. These fears are most likely after a financial crisis such as that associated with the Stock Market Crash of 1929.^{[citation needed]}

Neoclassical schools of economics which hold that economic agents make decisions based on real rather than nominal values contend that monetary efforts to lower nominal risk-free rates have no significant impact on the nominal interest rates charged by banks. A bank will not lend unless it can charge a (nominal) interest rate which is at least equal to the rate of inflation during the loan period. In an environment where banks are prohibited or discouraged by law from charging high rates of interest on loans, banks will be more reluctant to lend, since doing so would result in receiving a low (and possibly negative) real rate of return on investment. Unlike Keynesian theory, which claims that "liquidity traps" arise from fear or a hoarding mentality among banks, neoclassical theories argue that liquidity traps of this form do not exist and that monetary efforts to lower rates will have little, if any, effect on the quantity of real goods produced.

Note that even if the expected inflation rate is zero, nominal interest rates charged for loans will never fall below zero. Negative interest rates would imply banks paying borrowers to take loans. Furthermore, the liquidity advantages of holding money in an uncertain environment will set a non-zero, positive lower bound on the rate at which any agent will be willing to lend.^{[citation needed]}

[edit] Japan's liquidity trap

It has been suggested that the Japanese economy in the 1990s suffered from a "liquidity trap" scenario.^[4] This diagnosis prompted increased government spending and large budget deficits as a remedy. The failure of these measures to help the economy recover, combined with an explosion in the Japanese public debt, suggest that such a fiscal policy may not have been adequate.

Some economists believe that much of Japan's government spending followed a stop/go pattern and involved spending on unneeded infrastructure. American economist Paul Krugman suggests that what was needed was a central bank commitment to steady positive monetary growth, which would encourage inflationary expectations and lower expected real interest rates, which in turn would stimulate spending.^[5]

[edit] See also

• Deflation
• Flight-to-liquidity
• Stagflation
• Zero interest rate policy

[edit] Notes

[edit] References

• Eggertsson, Gauti B., 2008. "liquidity trap," The New Palgrave Dictionary of Economics, 2nd Edition.
• Krugman, Paul, 1999. "Thinking About the Liquidity Trap", Author's website, December,
• Mankiw, N. Gregory, 2006. "Macroeconomics" 6th ed.