Liquidity Trap vs Crowding Out
Liquidity Trap and Crowding Out are related concepts in AP Economics that students often mix up. In short: liquidity trap is a liquidity trap occurs when interest rates are so low that monetary policy can't stimulate the economy because people hoard cash instead of spending or investing. Meanwhile, crowding out is crowding out is the fall in private investment that happens when government borrowing pushes up real interest rates. Here is how they compare side by side.
A liquidity trap occurs when interest rates are so low that monetary policy can't stimulate the economy because people hoard cash instead of spending or investing.
With rates near zero, adding money does little because the public holds it rather than lending or spending. Monetary policy loses traction, so economists argue fiscal policy is more effective in a liquidity trap.
Crowding out is the fall in private investment that happens when government borrowing pushes up real interest rates.
When the government runs a deficit it borrows in the loanable funds market, raising the demand for loanable funds and the real interest rate. The higher rate discourages private investment and interest-sensitive spending, partly offsetting the expansionary fiscal policy. It is a key limitation of deficit-financed government spending.
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime.