Liquidity Trap
What is Liquidity Trap?
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.
Liquidity Trap: a worked example
Nominal GDP is $600 billion and the money supply is $120 billion, so velocity equals 600 divided by 120, or 5. The central bank buys bonds and lifts the money supply to $150 billion, a 25 percent increase. If velocity held at 5, the quantity equation MV equals PY would predict nominal GDP of 150 times 5, or $750 billion. Instead the policy rate is already sitting at 0.1 percent, banks park the new reserves rather than lend them, and households add the cash to their balances. Measured velocity falls to 4. Nominal GDP becomes 150 times 4, or $600 billion, exactly where it started. The 25 percent monetary injection bought no extra spending, because a 20 percent fall in velocity cancelled it out. That is the liquidity trap stated in arithmetic.
The mistake students make with liquidity trap
On the money market diagram students shift the money supply curve right and then read a lower interest rate off the sloped part of money demand. That is the reflex from every earlier problem, so it happens automatically. In a liquidity trap money demand is horizontal near the floor rate, because cash and short term bonds pay almost the same return and the public will absorb any quantity of money offered. Shifting a vertical money supply along that flat stretch leaves the interest rate unchanged, so investment does not rise and aggregate demand does not shift. Draw the flat segment first, then shift.
Liquidity Trap questions
What causes a liquidity trap?
Deep recessions with pessimistic expectations set it up. Firms that expect weak demand see few projects worth funding even at a rate near zero, so loan demand stays flat no matter how many reserves the banking system holds. Expected deflation makes it worse, because a falling price level raises the real interest rate even while the nominal rate sits on its floor. Banks carrying damaged balance sheets also prefer safe reserves to new lending. The central bank is left pushing on a nominal rate with nowhere further to fall.
How is a liquidity trap different from the zero lower bound?
The zero lower bound describes the interest rate itself, the point below which a central bank struggles to push nominal rates because holders would switch to cash instead. A liquidity trap describes what happens to policy at that point, namely that money demand goes flat and open market purchases stop moving either the rate or output. Hitting the bound is the condition, and the trap is the consequence for monetary policy.
What policy works in a liquidity trap?
Fiscal policy gains traction, because government spending or tax cuts raise aggregate demand directly rather than working through an interest rate that cannot fall. Crowding out is also weaker, since the extra borrowing does not push rates up much when money demand is flat. Central banks can still act through unconventional channels such as buying longer term assets or committing to keep rates low, which works on expectations rather than on the current short rate.
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