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What’s it? A liquidity trap is a situation in which an expansionary monetary policy cannot further lower interest rates. As a result, these policies are unable to generate economic growth or push up the inflation rate. In simpler terms, the central bank’s typical tools for stimulating the economy become ineffective, leaving them with limited options to fight recessions and deflation.
How does a liquidity trap work
The liquidity trap arises when the economy faces three situations at the same time:
- Nominal interest rate is near or at 0%
- The economy is in a recession or, worse, an economic depression
- Conventional monetary policy is less effective, and interest rates find it challenging to fall any further.
The liquidity trap usually arises when short-term nominal interest rates are at zero percent or near zero percent. The demand curve becomes elastic.
Authorities have more limited policy options. Since interest rates are so low, the central bank cannot lower them any further.
Every expansionary policy step by the monetary authorities failed. An increment in the money supply (for example, through a cut in the policy interest rate) does not encourage consumption or investment. People prefer to hold cash under their pillows.
A recession creates a high risk of default. Even if interest rates fall further, banks are unwilling to lend them, considering the high risk. As a result, the government can’t use interest rates as a tool to stimulate the economy.
Short-term real interest rates and nominal interest rates
As shown in the Fisher equation, the real interest rate equals the nominal interest rate minus the expected inflation rate. Or, if you reverse the equation, the nominal interest rate equals the real interest rate plus the expected inflation rate.
The nominal interest rate cannot be negative because no creditor (such as a bank) will lend money at a negative interest rate. If they do, their money is reduced. Rather than diminishing, lenders will likely prefer to put their money on their mattresses.
Causes of the liquidity trap
Several factors can conspire to create a liquidity trap, essentially jamming the brakes on economic growth:
Recessionary jitters
When an economy falls into recession, businesses become cautious. Even with lower borrowing costs thanks to central bank rate cuts, they see weak demand for their goods and services. Investing in new equipment or expanding production would likely lead to a glut of unsold products, pushing prices even lower. So, despite the incentive of cheap borrowing, businesses hold back on investment.
Lower interest rates usually make capital investments more profitable. The company bears a lower cost of funds. But because the recession took place, companies didn’t want to invest. They saw that the demand for goods and services was weak. If they invested, it would only result in a larger excess supply, pushing prices to fall further. Therefore, even though borrowing costs were cheaper, they did not want to take risks by investing.
Deflationary expectations
A liquidity trap can worsen deflation, where prices are continually falling. Here’s the trap: People might anticipate even lower prices in the future, so they delay spending today. This decrease in consumer spending further weakens demand, leading to even lower prices—a vicious cycle. Businesses see this drop in demand and become even more hesitant to invest, further slowing economic growth.
When demand weakens, deflation usually occurs. Deflation raises real interest rates (the nominal interest rate minus inflation expectations) very high, even if the nominal interest rate is zero. Say the deflation rate is -5%, and the nominal interest rate is 0%, so the real interest rate is 5%. The higher the deflation rate, the greater the real interest rate.
At a nominal interest rate of 0%, people prefer to hold cash because they can use it at any time. On the other hand, saving money will result in nothing.
Indeed, when there is deflation, the price level in the economy decreases. In real terms, money’s purchasing power increases. However, people tend to delay the purchase of goods and services.
For example, the household sees that the price of goods will fall in the next month. They will most likely delay their current purchases. And because deflation still exists in the next month, they also see that prices will continue to fall, and they again decide to postpone purchases, and so on. If that continues, household consumption (share of aggregate demand) will tend to stagnate.
Banking system strain
Continuous deflation raised real interest rates, jeopardizing investment and widening the output gap. This can turn the economy into a vicious circle.
If the recession lasts a long time, deflationary pressures will increase. Although interest rates are meager, companies are reluctant to increase production or invest in capital goods.
The new investment will only increase the market’s supply and deepen the price fall. Companies face a severe drop in demand for goods and services. Thus, increasing production (which in turn encourages economic growth) is an unreasonable option.
Deflation makes company revenues fall. The company faces downward pressure on selling prices. So, even if sales volume is constant, revenue will still fall.
For such reasons, further monetary policy easing is less effective at stimulating economic growth. Deflation increases the real value of debt (debt deflation), which hurts borrowers and increases their risk of default.
The risk of failure is also higher in the business sector, as many companies face financial deterioration. A fall in the price level reduces their income and ability to make money.
The high risk of debtor default can eventually lead to a banking crisis, and banks and other financial institutions are under intense pressure.
Banks are trying to limit new loans and write off existing ones. So, during the liquidity trap, investment falls not only due to a decrease in funds’ demand by the corporation. But, it is also due to the supply problems. Banks are more careful in extending credit.
Consequences of a liquidity trap
A liquidity trap throws a wrench into the central bank’s toolkit for managing the economy, leading to several negative consequences:
Stalled recovery: Normally, central banks can combat recessions by lowering interest rates to encourage borrowing and investment. However, when stuck in a liquidity trap, interest rates are already near zero. This crucial tool becomes unavailable, hindering efforts to revive the economy.
Deflationary spiral: A liquidity trap can worsen deflation, a situation where prices continuously fall. Here’s how: With low interest rates, people might hold onto their cash, expecting prices to drop further. This decrease in spending leads to even lower prices, creating a vicious cycle. Deflation discourages businesses from investing and hiring, further weakening the economy.
Debt burden grows heavier: Imagine you have a loan but interest rates suddenly drop to zero. Sounds good, right? Well, not entirely true in a liquidity trap. If deflation sets in, the value of money increases. This means the amount you owe stays the same, but it becomes relatively more expensive to repay as the value of your income (and everything else) decreases. This can strain businesses and households already burdened by debt.
Escaping the liquidity trap (potential solutions)
Because traditional monetary policy is ineffective, the government will adopt unconventional policies. There are several possible options.
The first is quantitative easing, which involves central banks purchasing large quantities of government bonds and other assets from financial institutions. This injects additional money into the economy, aiming to stimulate lending and economic activity. By increasing the money supply, QE can potentially lower long-term interest rates, even if short-term rates are already near zero.
The second is giving people cash right away (helicopter money). This is a more radical solution compared to other options. It involves the central bank electronically crediting bank accounts or distributing physical cash to the public. The goal is to directly boost aggregate demand by increasing household spending power. However, helicopter money is a controversial policy with concerns about inflation and potential misuse.
The third is providing guidance for low-interest-rate policies going forward (forward guidance). In this case, the central bank is committed to maintaining low-interest rates in the future and will continue to be maintained. The promise of sustained low interest rates makes businesses more confident about making new investments that stimulate consumption.
The fourth is to reduce the yield on government bonds and adopt expansionary fiscal policies. When the liquidity trap unfolded, Keynesians argued that the government should take a more active role. To stimulate the economy, the government should raise its spending, especially capital spending.
Fiscal policy is a discretionary political decision. Unlike businesses, the government is not profit-oriented. Therefore, the government can decide when to increase spending or not, regardless of economic conditions or interest rates.
An increase in government spending, such as spending on infrastructure, stimulates aggregate demand. That creates more jobs and income, allowing households to spend more money on goods and services. In the end, it will create a multiplier effect in the economy.
