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.
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
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.