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Liquidity Trap, Monetary policy and Fiscal Policy

  1. Liquidity Trap

The term liquidity trap was initially proposed by John Maynard Keynes in 1936. Several researchers and economists doubted about the practical application of this concept for many years. However, central banks turn out to be concerned with this phenomenon when the liquidity trap became a reality in some countries. The two main examples of liquidity traps happened in the Great Depression in the United States during the 1930s and in the Japan economic slump during the late 1990s.


  1. Ineffectiveness of Conventional Monetary Policy

Economists such as Paul Krugman and Ben Bernanke highlighted and discussed this subject and its enormous macroeconomic implications several times. Paul Krugman (1998) defined the liquidity trap as a situation in which monetary policy loses its effectiveness to stimulate economic growth because the nominal interest rate is nearly zero. When this happens, the opportunity cost of holding money becomes nil and even when the Central Bank increases the money supply to stimulate the economy, the economic agents will continue to accumulate money instead of investing it. Since the nominal interest rate cannot go below zero, we came to a situation in which the efforts of the monetary policy are ineffective. Moreover, one consequence of the liquidity trap is deflation. And, if deflation persists for a long period, individuals would expect negative inflation to continue.  Consequently, the real interest rate – which is defined as the nominal interest rate without expected inflation – will increase. This, in turn, harms private investment through increased real cost of borrowing and thus widens the output gap. And then the economy is in a vicious cycle of output stagnation.

Oliver Blanchard and David Johnson (2013) believe that the way to avoid an economy to get into a liquidity trap is by set higher average inflation. The higher the average nominal interest rate, more options the central bank has to decrease the nominal interest rate when a shock happens.
According to Paul Krugman and Robin Wells (2009), Japan experienced a significant increase in the prices of both stocks and real estate during the late 1980s. This resulted in a long period of economic stagnation – the Lost Decade.

During the 1990’s, Japan found itself in a liquidity trap when its long-term interest rates were almost at zero and short-term interest rates reached zero, which make impossible for the Japanese central bank to decrease even more the interest rate. The economic growth in Japan was almost nil and the prices were decreasing systematically. (Eggertsson and Woodfor 2004). The Japanese economy has stagnated for a long period and the Japanese governments used monetary and fiscal policy to try to solve this macroeconomic issue (Goyal and McKinnon 2003). According to Paul Krugman (2000), the bank of Japan found itself in a situation in which he could not increase demand. By 1988 interest rates in Japan were almost at the zero lower bound and monetary policies were not a solution anymore.
In an attempt to drive the economy to continuous growth, the bank of Japan responded by cutting interest rates until their limit.
A prolonged economic slump in Japan led to deflation from the late 1990s on. Deflation in Japan (-0.2 percent) was not so strong compared with the Great Depression case in which the inflation rate was around -6.7 percent. However, it persisted during a long period, from 1995 to 2005.  Deflation is likely to cause failures in the financial system which may, in turn, intensify a liquidity trap since the unpredicted deflation raises the real debt value.

  3. Solution for the Liquidity Trap

3.1. Fiscal Policy

When the effectiveness of monetary policy fails to boost the economy, it is imperative to search for other alternatives.
The classic Keynesian answer to the liquidity trap is expansionary fiscal policy. During recession periods, private saving tends to increase fast. Hence, expansionary fiscal policy helps to offset this increase in private sector saving and injects money into the circular flow.
Since expansionary fiscal policy has positive effects on output and investment, governments can create government spending policies to raise aggregate demand.
The Japanese government started an enormous expansionary fiscal policy during the 1930s. Several economists agree that this government spending was crucial; however, this measure was not enough to lead the economy to substantial growth and the Japanese economy remained depressed for a long time.
In the case of the Great Depression, the US government slightly increased deficit spending during the 1930s. Some years after, with the entry of US in the World War II, deficit spending increased dramatically, and it ended up the Great Depression.
The question that arises is how effective can be the use of fiscal policy in a liquidity trap.
An expansionary fiscal policy may lead to an increase in the size of a government’s budget deficit. This could lead markets to fear debt default and push up interest rates on government debt.
Paul Krugman (2000) believes this increase in government expenditures may conduce to a situation of high government debt when the interest rate becomes positive again.
Several researchers have recently highlighted the financing consequences of fiscal policy.
The literature seems to agree that fiscal spending needs to be provisional and combined with procedures that guarantee fiscal sustainability. This will preserve trust in the sustainability of public finances and support both the recovery and long-term economic growth.


3.2. Unconventional Monetary Policy: Quantitative Easing

In 2001 the Bank of Japan executed the quantitative easing policy and it was implemented again during the Great Recession in 2009 and afterward. Quantitative easing is one of the most used unconventional monetary tools to give response to the liquidity trap. It consists of purchases by central bank of long-term government bonds to decrease long-term interest rates, increase money supply and raise economic activity (Krishnamurthy and Vissing-Jorgensen 2011). The process is quite simple: Central banks buy government bonds with money created electronically and use it to purchase bonds from investors. This, in turn, will lead to an increase in the number of funds in the financial system. As the amount of money in circulation in the economy rises, financial institutions have the possibility to lend more. It can also drive down the interest rates even if they were almost reaching their limit level. This may lead to a situation where consumers and investors spend more, enhancing the economy.
The effectiveness of unconventional monetary tools seems to be a discussion that does not reach overall agreement.
While some economists believe that unconventional monetary policies tools can help in recession times, others defend that this method is not as reliable as conventional monetary policy.

To sum up, I believe this subject deserves political and economic concern since it occurred in the most powerful economies of the world and its macroeconomic implications are enormous.
It is important to find economic and political solutions to prevent economies to get in a liquidity trap and it seems essential to develop new efficient measures to overcome recession periods.





Krugman, Paul (2000) Thinking About the Liquidity Trap. Journal of the Japanese and International Economies

Werning, Ivan (2011) Managing a Liquidity Trap: Monetary and Fiscal Policy. Nber Working Paper Series

Krugman, Paul. (1998). ‘‘It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap.’’ Brookings Papers on Economic Activity.

Krishnamurthy, Arvind and Vissing-Jorgensen, Annette (2011) The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy.

Goyal, Rishi and McKinnon Ronald (2003). Japan’s Negative Risk Premium in Interest Rates: The Liquidity Trap and the Fall in Bank Lending.

Blanchard Oliver and Johnson David (2013) Macroeconomics.

Krugman Paul and Wells Robin (2009) Macroeconomics.


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Author: studentnovasbe

Master student in Nova Sbe

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