Liquidity trap

From Academic Kids

In economics, a liquidity trap is a situation when the economy is stagnant and the interest rate is equal to, or slightly above, 0 percent. In this kind of situation, people do not expect high returns on their financial or real investments and so keep their money on their bank accounts or hoards instead of investing it. This makes the recession even more severe. In "normal" times, the Central Bank could stimulate the economy by lowering the interest rate and thus increasing borrowing and fixed investment. But as the interest rate is already 0 percent or close to it, it cannot be decreased any further and the economy is "caught" in this trap.

There are, of course, other ways to stimulate the economy, varying interest rates are merely one very popular tool. The "liquidity trap" is a theory pointing to the impotence of monetary policy in depression situations, suggesting that fiscal expansion is needed instead.

John Maynard Keynes is usually seen as the inventor of the liquidity-trap theory. In his view, financial speculators are scared of suffering capital losses on non-money assets and thus hold money (liquid assets) instead. These fears are most likely after a financial crisis such as that associated with the crash of 1929. Further, if interest rates are extremely low, there is no place for them to go but up. That implies that bond prices will likely fall in the near future, causing capital losses.

A more recent view of the liquidity trap is that nominal interest rates cannot fall below zero, since no-one would voluntarily pay a borrower interest to borrow (i.e., pay negative nominal interest rates). This sets a minimum limit on nominal interest rates, one that may be slightly above zero because of the liquidity advantages of holding money.

It has been suggested that the Japanese economy in the 1990's suffered from a "liquidity trap" scenario. 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 fiscal policy may not have been adequate either. (Much of the 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 would stimulate spending.

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