Business, Legal & Accounting Glossary
A liquidity trap is a theory which occurs when the demand for money is so huge that people do not want to hold anything but money. One is better off holding cash to take advantage of an interest rate that will increase. A liquidity trap is said to occur when the interest rate is very low, then investors can buy the bonds. This is a theory from Keynes.
This would occur if, as thought of in the IS/LM curve, the IS curve intersects the LM curve (liquidity) at a highly horizontal or elastic portion of the LM curve. There is a contingent of contemporary economists who would disagree that conditions could exist such that a liquidity trap would occur.
Once an interest rate hits zero, conventional monetary policy will do nothing to stimulate the economy as the rates cannot be further decreased.
However, there is an unconventional policy that the central bank could adopt. The central bank could buy long-term bonds and other assets to inject cash into the nation’s economy.
“To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases, or possibly, expand the menu of assets that it buys…the chances of a serious deflation in the United States appear remote indeed, in large part because of our economy’s underlying strengths but also because of the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures.”
-Ben Bernanke, Speech to the National Economists Club, 21 November 2002, Washington, D.C.
The closest example of one was in Japan in the 90s. It was almost stagflation or even a depression. Interest rates were very low. Keynesians would say the government was not sufficiently interventionist, but the government did increase government spending and monetary expansionism which are Keynesian policies.
People can buy money in Japan (carry trade) and sell elsewhere due to the low-interest rate (arbitrage). The Japanese government will not raise the interest rate because it will decrease investment.
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This glossary post was last updated: 25th April, 2020 | 0 Views.