Liquidity Trap: Concept, Causes, Impacts, Possible Solutions

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.

When liquidity traps emerge

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

Usually, lower interest rates make capital investment more profitable. The company bears a lower cost of funds.

But, because the recession was in progress, companies didn’t want to invest. They see that the demand for goods and services is weak. If they invest, it will only result in larger excess supply, pushing prices to fall further. Therefore, even though borrowing cost is cheaper, they do not want to take risks by investing.

When demand is fragile, deflation will usually take place. Deflation makes 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. And, in real terms, the money’s purchasing power increases. But people will 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.

Bank failure

The continuous deflation made real interest rates rise. This jeopardizes investment and widens the output gap. It can bring 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 result in additional supply in the market. It will only deepen the fall in prices.

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 (known as debt deflation). It hurts borrowers and increases their risk of default.

In the business sector, the risk of failure is also higher, as many companies face financial deterioration. A fall in the price level reduces their income and their ability to make money.

The high risk of default by debtors can eventually lead to a banking crisis. 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.

Impacts of the liquidity trap

When the economy enters the liquidity trap, an increase in the money supply fails to lower interest rates and stimulate economic growth. Since nominal interest rates are generally capped at zero, the central bank cannot further reduce interest rates even if it so desires.

Furthermore, trying to stimulate the economy by injecting more money or liquidity through open market operations may be less effective. Therefore, in general, conventional monetary policy will not improve the situation.

Liquidity trap solutions

Because traditional monetary policy is ineffective, the government will adopt unconventional policies. There are several possible options.

The first is quantitative easing. It involves buying government debt securities on a more massive scale than ordinary open market operations.

The second is giving people cash right away (helicopter money). It is a more extreme solution than other options.

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 the adoption of expansionary fiscal policies.

When the liquidity trap unfolded, Keynesians argued that the government should take a more role. To stimulate the economy, the government should raise its spending, especially capital spending.

Fiscal policy is a discretionary policy and is a political decision. Unlike business, 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.