Liquidity trap

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In monetary economics, a liquidity trap occurs when the economy is stagnant, the nominal interest rate is close or equal to zero, and the monetary authority is unable to stimulate the economy with traditional monetary policy tools. In this kind of situation, people do not expect high returns on physical or financial investments, so they keep assets in short-term cash bank accounts or hoards rather than making long-term investments. This makes the recession even more severe.

In normal times, the monetary authority (usually a central bank or finance ministry) can stimulate the economy by lowering interest rate targets or increasing the monetary base. Either action should increase borrowing and lending, consumption, and fixed investment. When the relevant interest rate is already at or near zero, the monetary authority cannot lower it to stimulate the economy. The monetary authority can increase the overall quantity of money available to the economy, but traditional monetary policy tools do not inject new money directly into the economy. Rather, the new liquidity created must be injected into the real economy by way of financial intermediaries such as banks. In a liquidity trap environment, banks are unwilling to lend, so the central bank's newly-created liquidity is trapped behind unwilling lenders.

The liquidity trap theory applies to monetary policy in non-inflationary depressions. The theory does not apply to fiscal policies that may be able to stimulate the economy.

Milton Friedman suggested that a monetary authority can escape a liquidity trap by bypassing financial intermediaries to give money directly to consumers or businesses. This is referred to as a money gift or as helicopter money (this latter phrase is meant to call forth the image of a central banker hovering in a helicopter, dropping suitcases full of money to individuals). Political considerations make it difficult for a monetary authority to grant the money gift, because individuals and firms not receiving free money will exert political pressure. The monetary authority must act covertly to give gift money to specific individuals or firms without appearing to give money away. During the Great Depression in the United States, the Federal Reserve offered to buy any gold at a price well above current market prices. This was essentially a money gift to gold holders. In Japan in the 1980s, the Bank of Japan began buying newly-issued common stock and bond as a hidden money gift to firms.

John Maynard Keynes is usually seen as the inventor of the liquidity-trap theory. In his view, financial speculators fear the possibility of suffering capital losses on non-money assets and thus hold money (liquid assets) instead. These fears are most likely after a financial crisis such as that associated with the Stock Market Crash of 1929. Further, if interest rates are extremely low, there is no place for them to go but up. That implies that bond prices will likely fall in the near future, causing capital losses.

Neoclassical Economics, believing economic agents care about real consumption rather than nominal consumption, (that is to say, they care about what they get in real goods, not how many dollars of goods they get) deny the existence of a liquidity trap. Agents do not care about nominal interest rates, but real interest rates. With this in mind, along with a skepticism concerning whether or not changes in the nominal interest rate have any historical evidence suggesting they significantly affect real goods produced, neoclassicists suggest the concept of a liquidity trap arises from a fundamental confusion about the difference between real consumption and nominal consumption, or the failure to recognize that real values are what economic agents derive decisions from.

A more recent view of the liquidity trap is that nominal interest rates cannot fall below zero, since no-one would voluntarily pay an interest to a borrower (i.e., pay negative nominal interest rates). This sets a minimum limit on nominal interest rates, one that may be slightly above zero because of the liquidity advantages of holding money.

It has been suggested that the Japanese economy in the 1990's suffered from a "liquidity trap" scenario. This diagnosis prompted increased government spending and large budget deficits as a remedy. The failure of these measures to help the economy recover, combined with an explosion in the Japanese public debt suggest that fiscal policy may not have been adequate either. (Much of the government spending followed a stop/go pattern and involved spending on unneeded infrastructure.) American economist Paul Krugman suggests that, what was needed was a central bank commitment to steady positive monetary growth, which would encourage inflationary expectations and lower expected real interest rates, which would stimulate spending.