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The Liquidity Trap – History & Theory

History & Theoretical Concept

The liquidity trap is a state of macroeconomics inherent to (Neo-) Keynesian economic theory. Put simply: the term ”liquidity trap” refers to a situation in which nominal interest rates are so low that stimulating the economy through monetary policy is impossible. To understand the liquidity trap it is important to understand under what circumstances Keynes and Hicks developed the idea.

Keynes developed his theories and models in the light of the Great Depression in 1929 and subsequent years which certainly influenced his perception of the then prevailing state of macroeconomics and led to the publishing of his work the General Theory in 1936. The idea of the liquidity trap gained more substance through the summaries of Keynes’ fairly unapproachable theories through Hicks in the following year (1). The IS-LM model brings together the markets for money and for goods and – opposed to the classical models – focuses on the short-run instead of the long-run (”In the long-run, we’re all dead!”). Keynes’ changes in money demand and the assumption of sticky prices allowed for monetary policies to influence demand. Thus, by increasing nominal money supply (for simplicity reasons it is usually assumed that this is only done by the central bank) real money supply increases as well and expand consumption and investment in an economy. If now, given the excess money, the demand for bonds and consequently their prices increase as the nominal interest rate declines. This effect though was nowhere to be seen during the Great Depression in the United States.

Hicks argued to recognize a positive price floor to the short-run interest rate and that the long-run rate is based on regressive expectations about the future value. His reasoning was that nominal interest rates would never cross the threshold of zero interest rate as otherwise holding money would strictly dominate bonds as an asset (2). This leads to the money demand curve to be almost horizontal on its right side.
If now, the nominal interest rate reaches a level close to zero this would imply that the demand for money becomes infinitely elastic and hence monetary policy to boost demand ineffective. Assuming an economy in a depression (remember the context) this would mean that the economy is in a liquidity trap. Even with the interest rate being zero and thus bonds and money being equivalent assets monetary policy would remain ineffective.

An economy in a liquidity trap staying in recession for some time can experience deflation as a result. A persistent deflation will cause the real interest rate to rise which in return will disincentivize private investment through the high costs of borrowing. Therefore, output will further decrease with monetary policy still being ineffective. The economy finds itself in a vicious cycle.

There are two main solutions to a liquidity trap: Keynes suggests an increase of government spending to compensate the lack of private consumption and increase demand. Including the effect of the multiplier, the government will be able of driving the economy back to full-employment. A more monetarist approach suggests quantitative easing: the central bank provides liquidity to the economy by buying mostly long-term or toxic bonds or other securities with the purpose of lowering the interest rates

and thus making private investment feasible and attractive again (3). 

Real World Link

The 1930’s Great Depression in the United States is the most striking example of an economy in a liquidity trap. A second – universally not undisputed example – marks Japan in the 1990’s. The Japanese economy had suffered from recession and constant deflation since the early 90’s leading the Bank of Japan to decrease the interest rate continuously until reaching a zero interest rate in 1999. Further attempts of controlling for this phenomenon with quantitative easing as discussed above were undertaken since 2001.

It was widely agreed that Japan needed to induce private-sector expectations of higher future price levels and inflation in order to lower the real interest rate with nominal rate unchanged at 0%. The problem turned out to be that the attempts of quantitative easing were clearly considered as being temporary rather than permanent and thus failing to induce expectations about higher price levels (4). None of the attempts has been fruitful so far and as of 2016, Japan still remains in a liquidity trap. In order for Japan to restore the state of their economy fiscal policy to enhance productivity, real wage growth and international competitiveness need to support monetary policy actions. Furthermore, Japan depends on a more favourable global economic environment and financial conditions that can avoid expectations of declining long-term interest rates in many advanced economies (5).

(1) Blanchard, 2000: Macroeconomics. Massachusetts Institute of Technology, Prentice Hall International, Inc.
(2) Krugman, 1999: Thinking about the Liquidity Trap.
(3) Hiro Ito, Princeton University Press
(4) Svenson, 2006: Monetary Policy and Japan’s Liquidity Trap. Princeton University, Working Paper No. 126.
(5) Akram, 2016: Japan’s Liquidity Trap. Levy Economics Institute, Working Paper No. 862.


Author: studentnovasbe

Master student in Nova Sbe

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