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 ?
Yetman, "Capital Controls, Global Liquidity Traps and the International Policy Trilemma," NBER Working Paper No.
In their efforts to fight inflation, central banks keep interest rates high, which effectively created liquidity traps in these economies.
I don't wish to leave the impression that Congdon has completely overlooked the problems raised by liquidity traps.
While the book covers a vast range of financial meltdowns, from currency crashes and sovereign defaults to bank runs, liquidity traps, and inflation crises-highlighting the clustering-nature of such episodes-the authors point to a particular problem with short-term debt that constantly needs to be "rolled-over" or refinanced:
In addition to demonstrating how the emergence of risk premiums in money and capital markets can generate liquidity traps at positive interest rates and may drive economies into recessions, it shows the following: (1) Fiscal policy works even in a small, open economy under flexible exchange rates when the country is stuck in a liquidity trap; (2) Near the fringe of liquidity traps, there may be perfect traps, in which neither monetary nor fiscal policy works when used in isolation but policy coordination is called for; and (3) Massive financial crises in the domestic money market may even destabilize the economy.
Liquidity traps are rare in modern times, but the decade of economic stagnation suffered by Japan in the 1990s after the bursting of its financial bubble is cited as an example.
The government will strive to ease financial distress of SMEs in order to protect viable enterprises from falling into liquidity traps.
While not everyone agrees that liquidity traps are a serious possibility, in this Economic Commentary, we assume they are and discuss the merits and the drawbacks of these exchange-rate-based escapes.
In the same way that liquidity traps can be expunged from financial city centres and the free international flight of capital - flight in as well as out - so too can economies in Asia/Pacific help themselves by building in safety factors for future recessions.
Both have been used more widely -- indeed, taken to extreme levels -- to supplement the unconventional expansion of balance sheets in the context of liquidity traps.
But this is only true up to a certain point because liquidity traps may morph into perfect traps.
Krugman uses slow growth of M2 to infer liquidity traps (except in the United States in 2009), but growth of Japan's M2 plus CDs accelerated modestly from 1993 to 1998 when the monetary base did.