Liquidity trap
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In monetary economics, a liquidity trap occurs when 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, and can contribute to deflation.
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.
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[edit] Economist's perspectives
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. The term helicopter money is meant to portray the image of a central banker dropping money on people from a helicopter. 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 bonds 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 schools of economics which hold that economic agents make decisions based on real rather than nominal values contend that monetary efforts to lower nominal risk-free rates have no significant impact on the nominal interest rates charged by banks. A bank will not lend unless it can charge a (nominal) interest rate which is at least equal to the rate of inflation during the loan period. In an environment where banks are prohibited or discouraged by law from charging high rates of interest on loans, banks will be more relunctant to lend, since doing so would result in receiving a low (and possibly negative) real rate of return on investment. Unlike Keynesian theory, which claims that "liquidity traps" arise from fear or a hoarding mentality among banks, neoclassical theories argue that liquidity traps of this form do not exist and that monetary efforts to lower rates will have little, if any, effect on the quantity of real goods produced.
Note that even if the expected inflation rate is zero, nominal interest rates charged for loans will never fall below zero. Negative interest rates would imply banks paying borrowers to take loans. Furthermore, the liquidity advantages of holding money in an uncertain environment will set a non-zero, positive lower bound on the rate at which any agent will be willing to lend.
[edit] Japan's liquidity trap
It has been suggested that the Japanese economy in the 1990s 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.
[edit] See also
[edit] References
Krugman, Paul, "Thinking About the Liquidity Trap", Author's website, December, 1999
Mankiw, N. Gregory, "Macroeconomics" 6th ed. (2006)
