liquidity trap


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Liquidity Trap

A recession during which banks are unwilling to lend and nominal interest rates are already at or near zero. Because interest rates are so low, the central bank can do nothing further to expand the money supply. At the same time investors are unwilling to invest to help the economy grow because banks are unwilling to lend because their returns are so low. This extends the recession and indeed makes it worse. Many economists believe that the best way to end a liquidity trap is a money gift, where the government directly transfers money to consumers in hopes that they will spend it to spur investment.

liquidity trap

a situation where the INTEREST RATE is so low that people prefer to hold money (LIQUIDITY PREFERENCE) rather than invest it. At low rates of interest, the MONEY DEMAND SCHEDULE becomes infinitely elastic. In these circumstances, any attempt by monetary policy to lower interest rates in order to stimulate more INVESTMENT (see MONEY SUPPLY/SPENDING LINKAGES) will be futile, and will simply result in more money being held. KEYNES argued that in a depressed economy that is experiencing a liquidity trap the only way to stimulate investment is to increase GOVERNMENT EXPENDITURE or reduce TAXES in order to increase AGGREGATE DEMAND and improve business confidence about future prosperity, encouraging people to invest.
References in periodicals archive ?
2) Roberts (1995) noted a possible connection between Keynes' views on the liquidity trap and the constraints imposed by an international gold standard.
The issue is also highly relevant in the current era of low inflation: how to manage monetary policy to avoid deflation and potentially slipping into a liquidity trap (of the type many observers believe is happening in Japan) is similarly sensitive to how inflation is determined in the short run.
For instance, the experience of Japan since the early 1990s has generated new work on how to avoid and escape from a liquidity trap.
McCallum, "Inflation Targeting and the Liquidity Trap," NBER Working Paper No.
Krugman shows that the liquidity trap is not an artifact of the IS-LM model's incompleteness: even in a "modern" macroeconomic model based on intertemporal utility maximization by a representative agent, the liquidity trap can arise.
Specifically, they show that even if the steady state at which monetary policy is active is locally the unique equilibrium, there typically are an infinite number of equilibrium trajectories originating arbitrarily close to that steady state that converge to a liquidity trap -- that is, a steady state in which the nominal interest rate is near zero and inflation is possibly negative.
As Japan wrestles with deflation and a potential liquidity trap, Russia copes with fiscal insolvency and the possibility of hyperinflation, and the United States enjoys an era of approximate price stability, monetary topics are everywhere to be seen.
The insight that the solution to the problem of a liquidity trap involves affecting private sector expectations of the future price level is due to Paul Krugman.
In Japan there is no evidence for a liquidity trap.
Japan's economy has fallen into a so-called liquidity trap, from which further easing of monetary policy cannot rescue it.
He noted that a policy of inflation would reduce the real demand for money and move the economy out of a liquidity trap.
The Thai) economy is beginning to stabilize and do well, though there are still signs of the classical liquidity trap," Chatu Mongol Sonakul, governor of the Bank of Thailand, told a news conference in Tokyo.