What is Liquidity Trap?

Liquidity trap refers to a situation where the interest rates in an economy are at extremely low levels, and individuals prefer to hold their money in cash or cash equivalent form as they are uncertain about the performance of a nation’s economy. 

Liquidity traps occur when a country is trying to recover from a recession, and the government aims to boost the investment in the nation by reducing interest rates to facilitate borrowing. 

In a standard economy, such a reduction in interest rates encourages both borrowing and spending levels on part of both producers and consumers, as reflected through an increase in both private investments and consumer expenditure. This leads to an improvement in the aggregate demand levels of an economy, thereby leading to a corresponding rise in the GDP of the country as well. 

However, an expansionary monetary policy through lowering borrowing rates are ineffective when the interest rates are already close to 0, as any further reduction has no effect on the borrowing patterns of individuals. Due to prevailing depressed demand and production levels, individuals prefer storing their money in the advent of weakening economic conditions. 

Concept of a Liquidity Trap 

The concept of liquidity trap was first developed by economists J.M Keynes and J.H. Hicks in 1937, as an economic condition first observed after the Great Depression of the 1930s. As an aftereffect of one of the worst global economic crises, the benchmark interest rates as set by most countries were close to 0, in an attempt to boost demand and, thereby, supply levels. 

However, Keynes noted no significant improvement in the borrowing and investment patterns of markets all around the world, as individuals were uncertain about the economic scenario, and adopted a pessimistic outlook regarding any future investments. Also, unemployment levels were surging as an aftermath of the depression, causing reduced money supply in the hands of commoners. 

To overcome such liquidity traps, economist Keynes suggested a fiscal pay-out policy to be adopted by governments all around the world, which was, later incorporated in the IS-LM model developed by Hicks. 

As per renowned economists, massive government expenditure will increase the money supply in an economy, consequently leading higher aggregate demand levels, and hence, acts as a solution to a liquidity trap in economics. This is one of the first phases of recovery from depression experienced by countries in a business cycle. 

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What Leads to a Liquidity Trap?

A pessimistic outlook regarding investment is developed amongst individuals in an economy following a recession, as individuals expect to make no real gains through the stock market. Such a bearish outlook in the stock market leads to an increased savings values of individuals, as they expect the economic condition to falter even further. In such situations, the implications of liquidity trap are limited since any further fall in the interest rates is not possible (as they are already close to 0). 

Implications of a Liquidity Trap

One of the major pointers to understand while analysing a liquidity trap and its implications are its effect on the stock and bond markets, respectively. Investment in equity is affected significantly as individuals are ambiguous about the performance of companies in the near future. This reduces the cash flows of these businesses, severely affecting their production levels, consequently impacting the GDP of a country. 

Investments in the bond market reduce significantly as well, as bond prices and interest rates are inversely related. As bonds are typically associated with a fixed interest regime, any rise in the market interest rates causes investors to switch to corresponding investment schemes, such as fixed deposits. This reduces the demand for bonds, consequently leading to a steep bond price fall. 

In the event of liquidity traps, individuals expect the interest rate levels to rise from the negligible levels over time, thereby leading to a fall in the bond prices. Hence, in fear of capital losses, individuals prefer storing their money in cash or standard savings account instead of investing the same.  

Thus, expansionary monetary policy (through lowering interest rates) fails to generate any impact in boosting investment levels in a country. Individuals prefer holding their funds instead of investing the same in fear of inadequate returns and/or market uncertainty. 

Indicators of a Liquidity Trap 

  • Low-interest rates – 

The primary indicator of a liquidity trap is persistently low-interest rate levels mandated by the central bank of a country for a prolonged period. Though the primary aim of such government policies is to ensure robust economic activity, a liquidity trap can soon develop if not monitored closely. 

  • Recessionary trends – 

Typically, liquidity traps occur when an economy is recovering from a recession. As governments try to boost economic growth through expansionary policies to increase spending and investment, a contrary effect through a rise in savings level is noticed in the market if interest rates are kept too low (close to zero) for a long time. 

  • Unemployment – 

An effect of recession is surging levels of unemployment in a country, which implies reduced incomes in the hands of consumers. With a lower fund base, individuals tend to save any surplus funds for meeting any emergency expenses in the future, instead of investing/spending it. Thus, a reduction in interest rates tends to yield no results with respect to the revival of an economy. 

  • Deflation – 

Depressed consumer demand levels lead to a consistent fall in the price level of an economy. Such trends have a negative impact on the economic growth rate of a country, as it discourages producers from producing higher quantities in response to lower profits. This generates an adverse impact on the GDP of a country. 

How to Overcome a Liquidity Trap?

One of the major methods of negating liquidity trap in economics is through expansionary fiscal policy. An increased government spending coupled with lower taxes has a positive impact on an economy, as it encourages production, which, in turn, increases employment levels in a country. Consequently, as people have higher disposable income available for spending rise in the aggregate demand levels is noticed, as well as an increase in the investment patterns. 

A massive reduction in the price level can also boost the spending patterns of individuals, consequently breaking the pattern of hoarding money and on-going liquidity trap scenario. 

Liquidity Trap Examples – Japan 

A slowdown in the Japanese economy was first noticed during the 1990s, following which standard interest rates of the country fell drastically. As consumer and global investment confidence faltered, a fall in Nikkei 25 values, the benchmark index of Tokyo, was noticed. As of 2019, the interest rates in Japan are operating at – 0.1%. 

A liquidity trap is a major implication of recession and can have a devastating impact on the growth of an economy, if not solved immediately. While expansionary fiscal policies work in most cases, highly developed economies often face challenges in reviving its aggregate demand level in the event of liquidity traps. 

While individuals tend to hoard their wealth until economic stability, experienced investors often take advantage of this situation by making value purchases of stocks at lower trading prices. This enables them to enjoy higher rewards (through capital gains) when the economy recovers, as the prices of such securities increase during times of economic booms.