The building block of Keynesian economics lies in its belief that spending components like consumption and investment are dependent on changes in output. Thus, when consumption rises, it causes the output to rise proportionately.
This property is essentially important when understanding the effects of monetary and fiscal policies on an economy. Although these policies are essentially meant to stabilise the negative economic shocks, certain contradictory economic situations like liquidity traps turn these policies fruitless. Read on to know more about liquidity trap and its implications on a country’s economy.
What is Liquidity Trap?
A liquidity trap is an adverse economic situation where expansionary monetary policies fail to revive the economy. Such conditions lead to a high propensity to save because consumers are willing to hold on to cash or cash derivatives. The most crucial change in liquidity traps is that interest rates are too low to drive people toward investments.
Economist John Maynard Keynes first formulated the liquidity trap definition right after the great depression of the 1930s. Unlike an inflationary situation, liquidity traps are deflationary occurrences that cause prices to fall beyond a threshold. This leads to a situation where wages and prices remain constant, thus contributing to a lack of demand.
What Causes Liquidity Trap?
When an economy experiences a decrease in economic activity, it can lower production, consumption and investment expenditure. In the absence of a proper fiscal or monetary policy, there is not enough thrust to boost productivity. In such situations, the stock markets also show no signs of recovery and profit-making.
Statistics show that with a constant deflation rate, the interest rate rises. This causes the downfall of investment expenditure and income, which widens the output gap. The wider the gap, the more viscous the economy is, implying the inefficacy of expansionary monetary policy.
The above explanation is enough to explain the -6.7% inflation rate in the US during the great depression. Since the real debt value increased, borrowers found it difficult to repay debts and instead chose to hold on to their assets. Experts believe that an economy must be in an inherent slump to immerse itself in a liquidity trap.
Consequently, a crunch in cash flow implies that banks and financial institutions do not have enough reserves. In such situations, the central bank’s policy to undertake expansionary monetary policy fails since rates of interest are too low to force consumers to invest. This vicious cycle of credit crunch also affects future monetary policies.
A liquidity trap is a situation when consumers choose to hoard cash which results in low interest rates. An expansionary monetary policy is therefore not significant during such a situation and cannot boost consumption. As a liquidity trap is not a value but a situation, it cannot be expressed with a formula.
What are the Indicators of a Liquidity Trap?
There are certain indicators that suggest that the economy might be going through an adverse liquidity trap situation. They are as follows:
Low Interest rates: Liquidity traps are characterised by insistently low-interest rates. Often, the Central Bank finds it difficult to sustain such interest rates for a longer time. These traps can appear from ineffective government policies where lack of monitoring can often lead to such deflationary situations.
Recessionary trends: Keynes argued that liquidity traps might appear during the recovery stage of a recessionary economy. Expansionary fiscal and monetary policies, for example, fail to boost the income level with respect to extremely low-interest rates.
Unemployment: Phillip’s curve theory explains the inverse relationship between unemployment and inflation. Evidently, a deflationary situation will increase unemployment, implying that consumers have less money in their hands. Any surplus funds cater to the emergency needs of the consumers instead of them investing or spending it.
Deflation: The liquidity trap prolongs a deflationary period and creates a vicious cycle of stagnant outputs. This causes a fall in the overall price levels and thus helps in disrupting the economic balance. Deflationary situations also result in lower profit generation by business ventures and an obvious impact on the GDP.
Graphical Representation of Liquidity Trap
Before explaining liquidity traps graphically, it is imperative to understand the IS-LM curve. The Investment-Savings and Liquidity preference-Money supply curve represents the basis of a Keynesian macroeconomic model.
The IS curve represents the locus of all points for different values of income and interest rates where investment equals savings. The LM curve represents the locus of points where money supply equals money demand.
Both these curves represent the equilibrium values of income (y) and interest rates (r). Figure 1 shows the normal equilibrium condition of an IS-LM curve. It shows the values of income and interest rate for which both the consumer market and money market is in equilibrium. However, things change when the economy faces a liquidity trap situation.
Keynes stated that owing to the low rates of interest in a deflationary situation, money demand is completely elastic. Figure 2 shows that the interest rate pertaining to this situation cannot fall beyond this point. Any further expansionary monetary policy (raising money supply, for example) will not alter ‘y’ or ‘r’. Thus, any attempt to raise investment and consumption by lowering interest rates will be futile.
It is crucial to understand the power of expectations. Keynes noted that altering the interest rate is proportional to people’s expectations about the interest rate. However, statistics ascertain that a liquidity trap is only conceptually possible. Despite similar situations troubling economists, a fall in interest rate beyond a critical limit is practically impossible because expectations would revive its value eventually.
What Factors Indicate a Liquidity Trap?
The primary indication of a liquidity trap situation is the decrease in price levels when the central bank increases money supply. An expectation of a further fall in prices discourages people from making purchases. Some major indications of an adverse economic condition facilitated by such traps are as below:
Stagnation of wage rates: Owing to the reluctance of companies to hire new employees, wages become stagnant. Keynes states that without a sufficient rise in incomes, people purchase the bare necessities and save more. This further contributes to a lack of demand.
Stagnation of business expansion: Even with an extremely low interest rate, business enterprises prefer to make no further investments. While buying back stocks and boosting stock prices is an option, it does not contribute to the deflationary situation. With lack of demand, companies do not see consumers making capital purchases.
Inefficacy of rising money supply: A typical case of expansionary monetary policy indicates that inflation grows by 0.54% for every 1 unit rise in money supply. However, in liquidity trap situations, the focus is mainly on saving and least on consumption. This implies a rise in cash and cash derivatives instead of higher-yielding assets like bonds.
What is an Example of a Liquidity Trap?
Like the US in the 1930s, Japan is the perfect modern-day liquidity trap example. Since interest rates have been nearing zero, the Central bank bought back government debt to boost the economy. However, the expectation of lower interest rates prevented consumers from making substantial purchases. With stagnant pay and insufficient capital to continue production, companies have stopped their hiring processes.
While the Japanese government has constantly been trying to boost the economy, its exclusive foreign policies discourage granting citizenship to young immigrants. Thus, with a constantly ageing population, there is a constant rise in their propensity to save more. Moreover, with a monopoly-like power, manufacturers prevent dispersal of free market forces and innovation.
How to Get Out of a Liquidity Trap?
The most obvious solution to the liquidity trap problem is revival of interest rates. However, the vicious nature of liquidity traps makes it difficult to raise interest rates. Five possible liquidity trap solutions are:
Raising interest rates: The central bank can try solving the problem of liquidity trap by raising interest rates. An increase in short-term interest rates can incentivise people to consume and invest more. High-interest rates also make banks participate in the process of increasing money velocity.
Expansionary Fiscal Policy: Economists believe that introducing expansionary fiscal policies can help deal with adverse economic conditions. Thus, decreasing the tax rate or increasing government expenditure can help get out of the trap. Consequently, it also creates employment opportunities, thereby boosting inflation.
Financial innovation and global rebalancing: Economists believe that financial innovation can create financial assets like stocks, bonds and derivatives that can prompt consumers to hold less cash. Moreover, globalisation has enabled global rebalancing, whereby the government can end the liquidity trap by engaging in international trade.
Price rebalancing: When price levels fall too low, consumers may indulge in purchasing more. Consumers may choose to hold more household goods or assets like stocks and bonds. Moreover, investors will also resume buying assets owing to the future reward it holds.
Relation between Liquidity Trap & Inflation and Interest Rates
Liquidity traps are adverse situations wheninterest rates fall too low to incentivise consumption or investments. As shown in the diagram above, consumers choose to hold cash and cash derivatives in the liquidity trap zone because prices are too low.
This is basically the opposite of inflation. While inflation reduces the value of money in an economy, deflation makes cash more attractive to the people. When deflation is persistent and combined with an extremely low nominal interest rate, it leads to output stagnation by making the liquidity constraint more binding.
What are the Things to Keep in Mind about Liquidity Traps?
The Keynesian idea of liquidity trap throws light on the ineffectiveness of monetary policies. Like most economic indicators, a trap situation is also psychologically-induced because consumers choose to hold cash instead of investing. Sudden favouritism towards hoarding cash decreases cash flow in the economy.
Graphically, liquidity trap situations are represented by a horizontal money demand. Any change in money supply will not change interest rates because they are too low to decrease further. Study shows that expectations-driven liquidity traps are different from fundamentally-driven ones.
Policy design for solving the problem of liquidity traps becomes exceptionally difficult in case of expectations-driven traps. Factually, occasional fundamentally-driven traps are beneficial for reaching a strict positive inflation target. Central banks can also adopt inflation-conservative objective functions to achieve these targets.
Liquidity traps are double-edged hurdles that can even render expansionary fiscal policies useless. Liquidity traps are not restricted to cash but also other assets like bonds. The adoption of a clever mix of policies can eventually lead an economy out of such an adverse economic situation.
FAQs on Liquidity Trap
Q1. What are the macroeconomic implications of liquidity traps?
Ans. The most crucial implication of a liquidity trap is its ability to destabilise the economy characterised by extremely low interest rates. Plus, it can also render fiscal and monetary policies useless.
Q2. What are the changes in the LM curve when an economy is in a liquidity trap?
Ans. The LM curve normally turns flat in liquidity trap situations because of extremely low (and sustaining) interest rates. This implies that consumers and investors are preferring to hold cash for liquidity.
Q3. How can liquidity traps be cured?
Ans. The central bank can raise interest rates, thus prompting people to invest more. A general drop in prices can force people to consume and invest more. An increase in government spending can instil confidence in the economy, thus boosting employment.
Q4. What are the factors on which interest rates depend?
Ans. Interest rates depend on various factors pertaining to credit and debit scenarios. Thus, factors like credit score, loan to value ratio and debt-to-income ratio affect interest rates.
Q5. Why do people hoard money during a liquidity trap?
Ans. A liquidity trap is caused when people choose to save cash because they expect an adverse event such as insufficient demand, unemployment, war or deflation. Once consumers prefer to save rather than invest, all monetary policies become ineffective.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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