Liquidity Trap

The most fundamental element of economics is the concept of supply and demand. Every economics textbook emphasizes the importance of supply and demand, no matter what the topic is. Therefore, supply and demand become an intuition for every economics student as well as established economists. On the other hand, in this vast ocean of economics literature, there are few places where the demand becomes a mundane idea. In these places, our economic policies fail, and our assumptions do not hold. This lack of balance is generally a cause of agent behavior. One of the prominent examples of failure in demand is the liquidity trap. If you are wondering about the failure of the supply and demand relationship and the liquidity trap, keep reading!

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    Liquidity Trap Definition

    The liquidity trap definition is - a situation where economic agents prefer to keep their savings instead of spending them even with respect to near zero or zero interest rates.

    The essence of the definition of the liquidity trap takes place between the agent’s behavior and the interest rates. Coined by John Maynard Keynes, the theory illustrates a situation where agents are unresponsive to a decrease in interest rates.

    The liquidity trap is a situation where agents prefer to keep their savings instead of spending them even with respect to near zero or zero interest rates.

    This scenario is rather different from what we expect from a well-functioning economy. In a well-functioning economy, lower interest rates will increase spending and decrease savings. This is rather logical. You can think of this relationship in a more concrete way if you think of an investor.

    Let us assume that Kyle wants to open a new third-wave coffee shop. As he researches the price of the necessary equipment, he realizes he is way short on money to open a coffee shop. In this case, Kyle doesn’t have many options. He goes to a bank to get a loan. The bank is willing to give him a loan with a 1.5% interest rate. It seems like a good deal, and Kyle proceeds to open his new coffee house. On the other hand, what would happen if the interest rates were higher? If the interest rates were significantly higher, Kyle could have decided not to open a coffee shop at all.

    Like in this previous example, lower interest rates will cause higher amounts of investments in a country’s economy. Not just due to investments but also because of the decreasing savings and people’s tendency toward spending, lower interest rates will promote increased heat in an economy. This is rather reasonable since if interest rates were low, instead of saving your money, you would rather spend it on different commodities or debt instruments.

    Debt instruments are assets that generate passive income for the holders. The most common example of debt instruments is government bonds.

    On the contrary, if an economy is in a liquidity trap, the change in the interest rates will not change the agent’s behavior.

    Causes of Liquidity Trap

    The causes of liquidity trap are:

    • changes in precautionary money demand
    • changes in speculative money demand

    The main cause of the liquidity trap is agent behavior and expectations. According to Keynes, people demand money for three main reasons. The most obvious type of demand is caused by transactions. Transaction demand is the demand for money to manage our daily transactions, such as buying commodities or spending money on services. The second cause for money demand is precautionary demand. The precautionary money demand is caused by people’s estimation of future risks.

    An example of precautionary demand can be given as follows. If an agent is expecting a war or some natural disaster, she will hold her money in liquid form instead of investing it in some assets. Indeed this is a good call since, in situations like war, she may not get her money back or she may not get it in the expected time.

    The final demand for money is caused by speculative demand. If people would believe that asset prices will change in the future and the market will act differently, they will save their money to earn more profit in the future.The last two types of money demand are the reasons for the liquidity trap. If people are expecting a recession in the future, they will not buy assets. This hoarding behavior can also be seen in the speculative demand for money. If people are expecting lower bond prices in the future, they will not invest in bonds in the present, no matter what the interest rates are. This type of hoarding behavior can lead to a vicious cycle where fiscal policy becomes ineffective.

    This is rather similar to waiting for Black Friday. If you are expecting a discount on the good that you are going to purchase in the future, you will not buy it at the moment. In a liquidity trap, people assume that the prices of the bonds are already too high and the interest rates are extremely low. Therefore, they are expecting a decrease in prices. While waiting for this decrease, they will keep their money and not spend it on anything else.

    Liquidity Trap Monetary Policy

    It is rather a common method to stimulate a country’s economy when it is necessary with interest rates. This is one of the most fundamental instruments that central banks have. To lower the interest rates, central banks increase the money supply. We can illustrate the relationship with the following graph.

    The Liquidity Trap Increased money supply in an economy StudySmarterFig. 1 - Increased money supply in an economy

    As can be seen in the first figure, the increased money supply will shift the vertical money supply curve towards the right (from Ms1 to Ms2). The intersection between money supply and money demand, which determines the interest rate, decreases when we compare it to the past.

    This change should increase the prices of the bonds since agents will prefer more bonds issued with lower interest rates. Nonetheless, if the interest rates can't get any lower than they already are, people will keep money due to speculative money demand. This is generally illustrated as follows.

    The Liquidity Trap Effect of increased money supply in a liquidity trap StudySmarterFig. 2 - Effect of increased money supply in a liquidity trap

    As you can see in Figure 2, an increased money supply doesn’t affect the interest rates. Since the elasticity of money demand at that level is infinite, the money supply doesn’t change the rate of interest.

    If you need to remember your past knowledge to understand these graphs, feel free to check our explanations of the Interest Rates and The Money Demand Curve!

    Liquidity Trap Fiscal Policy

    One solution for the liquidity trap is an expansion in the fiscal policy. This solution was offered by Keynes in the aftermath of the Great Depression. The United States followed Keynes’ advice, and the policy was effective against the liquidity trap caused by the Great Depression. We can observe the effect of the expansion in the fiscal policy during a liquidity trap with an IS-LM model. Let's start by reminding ourselves of the effects of the Monetary Policy in IS-LM model first.

    The Liquidity Trap Monetary policy effect under normal conditions StudySmarterFig. 3 - Monetary policy effect under normal conditions

    In Figure 3, we have the classical IS-LM model. The horizontal axis represents the total output, \(Y\) and the vertical axis represents the interest rates, \(i\). Under normal conditions, an expansion in the monetary policy will increase the level of output. This is represented by the shift from \(LM_1\) to \(LM_2\). On the other hand, if an economy is in a liquidity trap, the monetary policy will be ineffective because the LM curve will be horizontal. This can be illustrated as shown in Figure 4 below.

    The liquidity trap a shift in the LM curve under the liquidity trap StudySmarterFig. 4 - A shift in the LM curve under the liquidity trap

    Therefore, monetary policy will be ineffective in a liquidity trap for adjusting the level of output. In such a scenario, as mentioned by Keynes, an expansion in the fiscal policy will increase the level of output. We demonstrated this effect in Figure 5.

    The liquidity trap a shift in the IS curve under the liquidity trap StudySmarterFig. 5 - A shift in the IS curve under the liquidity trap

    An expansion in the fiscal policy can indeed increase the total level of output since it may encourage society to spend more.

    Liquidity Trap Examples

    There are plenty of examples of the liquidity trap in history:

    • Aftermath of the Great Depression in the United States
    • Aftermath of the Great Depression in the United Kingdom
    • Aftermath of the 1990s economic crisis in Japan

    In this section, we are going to give one historical and one hypothetical example of the liquidity trap.

    Let’s assume that you decided to put some money aside after receiving your income. In a few months, you realize that you want to invest the savings that you have accumulated. Now imagine a scenario where you have two options. One is buying government bonds and the other one is loaning it to a bank with a steady interest rate.

    After a quick research, you found out that everyone talks about the economy being in a liquidity trap. With respect to that, people think that the prices of government bonds fluctuate at the top, and they believe that the prices will decrease in the near future.

    This means that buying government bonds will not be a good investment. You can think of this as buying a commodity while knowing that there will be a discount next week. As a rational human being, you will avoid this scenario since you do not want to lose your precious savings. You share this intuition with society.

    On the opposite side of the spectrum, the central bank thinks that the economy is at a slow pace, and they believe that they can overcome this if they encourage spending. Nonetheless, interest rates are already near-zero and they don’t want to decrease interest rates to a much lower point.

    This scenario illustrates a liquidity trap. Since the demand for money is infinitely elastic, if the central bank decides to lower the interest rates in this environment, people will not start investing in government bonds due to the fact that they believe that prices will go down. Thus, interest rates become irrelevant.

    Perhaps the most commonly known liquidity trap in history is the one that is still lasting in Japan. With quick internet research, you will find out that the current interest rate in Japan is negative.

    This may sound surprising to anyone when you hear it for the first time. Japan has been in a liquidity trap since the aftermath of the financial crisis of 1990. After the financial crisis, the country’s economy was dragged into a recession. To overcome this recession, the Japanese Central Bank decided to lower the interest rates. As a result, Japanese people hold onto their money instead of spending it. Over the years, decreased interest rates have become a chronic part of the economic structure. Currently Japanese economy is still in a liquidity trap.

    Liquidity Trap Solution

    The liquidity trap generally is a chronic problem that is stubborn for solutions since it is directly related to the agent’s behavior. Nonetheless, there are some suggestions to solve this problem. We can group them under three main categories:

    • New opportunities in the market
    • Irresistible costs
    • Expansion in fiscal policies.

    If you are wondering how fiscal policies work, you can read our explanation of Fiscal Policy!

    New opportunities in the market are a solution that can encourage people to start investing. If new investment opportunities, such as innovations, arise in the market, they may offer extreme profits in the future. Therefore, people may decide to spend their savings on these new opportunities. This situation can also be seen when costs become irresistible. In this scenario, costs become so absurd that people will spend their savings, and this will help the economy to get out of a recession. Finally, expansion in fiscal policies may promote spending. For example, lowering tax rates may cause people to start spending their savings.

    Liquidity Trap - Key takeaways

    • The liquidity trap is a point where money demand is infinitely elastic and people cease to invest in anything, regardless of interest rates.
    • The most well-known example of the liquidity trap is the Japanese economy in the aftermath of the 1990s.
    • Expansion in fiscal policies, extremely low costs, or the creation of new market opportunities may help an economy to get out of a liquidity trap.
    Frequently Asked Questions about Liquidity Trap

    What is meant by a liquidity trap?

    The liquidity trap is a situation where agents prefer to keep their savings instead of spending them even with respect to near zero or zero interest rates.

    Is fiscal policy effective in a liquidity trap?

    Fiscal policies may be effective in a liquidity trap.

    How do you escape liquidity trap?

    Escape from the liquidity trap requires any policy that can encourage spending. Expansion in public policies, extremely low costs, or new opportunities in the market may create tendencies toward spending.

    Does a liquidity trap cause inflation?

    The liquidity trap doesn’t cause inflation, but expansion in fiscal and public policies to escape from a liquidity trap can cause inflation.

    What causes liquidity trap?

    Increased speculative and precautionary money demand causes a liquidity trap. In these scenarios, people will keep their money in their pockets either due to future risks or future investment opportunities.

    Who proposed concept of liquidity trap?

    The concept of liquidity trap was coined by John Maynard Keynes.

    Test your knowledge with multiple choice flashcards

    Which one of the following can not be an example of the solution for the liquidity trap?

    Japanese economy got stuck in a liquidity trap after the economic crisis of 1990.

    Using monetary policies can be effective against the liquidity trap.

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