The liquidity trap is a situation described by representatives of the Keynesian school of economics, when government injections of cash into the banking system cannot reduce the interest rate. That is, this is a separate case when monetary policy turns out to be ineffective. The main cause of the liquidity trap is thought to be negative consumer expectations that cause people to save a large portion of their income. This period is well characterized by "free" loans with almost zero interest rates, which do not affect the price level.
The concept of liquidity
Why do many people prefer to keep their savings in cash rather than buying, for example, real estate? It's all about liquidity. This economic term refers to the ability of assets to be quickly sold at a price close to the market. Cash is the most liquid asset. You can buy everything you need right away. Somewhat less liquidity have money in bank accounts. The situation is already more complicated with bills of exchange and securities. In order to buy something, they must first be sold. And here we have to decide what is more important for us: to get as close as possible to their market price or to do everything quickly.
Followed by accounts receivable, inventories of goods and raw materials, machinery, equipment, buildings, structures, construction in progress. However, you need to understand that the money that is hidden under the mattress at home does not bring any income to their owner. They just lie and wait in the wings. But this is a necessary price for their high liquidity. The level of risk is directly proportional to the amount of possible profit.
What is a liquidity trap?
The original concept is connected with the phenomenon, which was expressed in the absence of a decrease in interest rates with an increase in the money supply in circulation. This completely contradicts the IS-LM model of the monetarists. Typically, central banks cut interest rates in this way. They buy back bonds, creating an influx of new cash. Keynesians see monetary weakness here.
When a liquidity trap occurs, a further increase in the amount of cash in circulation has no effect on the economy. This situation is usually associated with low interest on bonds, as a result of which they become equivalent to money. The population strives not to satisfy their ever-growing needs, but to accumulate. Such situationusually associated with negative expectations in society. For example, on the eve of a war or during a crisis.
Causes of occurrence
At the beginning of the Keynesian revolution in the 1930s and 1940s, various representatives of the neoclassical movement tried to minimize the impact of this situation. They argued that the liquidity trap is not evidence of the ineffectiveness of monetary policy. In their opinion, the whole point of the latter is not to lower interest rates to stimulate the economy.
Don Patinkin and Lloyd Metzler drew attention to the existence of the so-called Pigou effect. The stock of real money, as scientists have argued, is an element of the aggregate demand function for goods, so it will directly affect the investment curve. Therefore, monetary policy can stimulate the economy even when it is in a liquidity trap. Many economists deny the existence of the Pigou effect or speak of its insignificance.
Criticism of the concept
Some representatives of the Austrian school of economics reject Keynes's theory of the preference for liquid monetary assets. They pay attention to the fact that the lack of investment in a certain period is compensated by its excess in other time periods. Other schools of economics highlight the inability of central banks to stimulate the national economy with a small asset price. Scott Sumner generally opposes the idea of the existence of the situation in question.
Interest in the concept resumed after the global financial crisis, when some economists believed that direct cash injections into households were needed to improve the situation.
Investment trap
This situation is related to the one discussed above. The investment trap is expressed in the fact that the IS line on the chart occupies a completely perpendicular position. Therefore, a shift in the LM curve cannot change real national income. Printing money and investing it in this case is completely useless. This trap is due to the fact that the demand for investment can be perfectly inelastic with respect to the interest rate. Eliminate it with the help of the "property effect".
In theory
Neoclassicists believed that an increase in the money supply would still stimulate the economy. This is due to the fact that uninvested resources will someday be invested. Therefore, it is still necessary to print money in crisis situations. This was the Bank of Japan's hope in 2001 when it launched its "quantitative easing" policy.
The authorities of the USA and some European countries argued in the same way during the global financial crisis. Instead of giving away free loans and lowering interest rates further, they sought to stimulate the economy in other ways.
In practice
When Japan began a long period of stagnation, the concept of the liquidity trap became relevant again. Interest rates were practically zero. At that time, no one had yet guessed that, over time, banks in some Western countriesagree to lend $100 and get back a smaller amount. Keynesians considered low but positive interest rates. However, today economists are considering a liquidity trap due to the existence of what is called "free loans". The interest rate on them is very close to zero. This creates a liquidity trap.
An example of such a situation is the global financial crisis. During this period, interest rates on short-term loans in the US and Europe were very close to zero. Economist Paul Krugman said the developed world is in a liquidity trap. He noted that the tripling of the US money supply between 2008 and 2011 had no significant effect on the price level.
Problem Solving
The opinion that monetary policy at low interest rates cannot stimulate the economy is quite popular. It is defended by such famous scientists as Paul Krugman, Gauti Eggertsson and Michael Woodford. However, Milton Friedman, the founder of monetarism, saw no problem with low interest rates. He believed that the central bank should increase the money supply even if they are equal to zero.
The government should continue to buy bonds. Friedman believed that central banks could always force consumers to spend their savings and provoke inflation. He used the example of an airplane dropping dollars. Households collect them and put them in equal piles. This situation is also possible in real life. For example, the central bank can finance the budget deficit directly. Willem Buiter agrees with this point of view. He believes that direct cash injections can always increase demand and inflation. Therefore, monetary policy cannot be considered ineffective even in a liquidity trap.
