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.

Collins Dictionary of Economics, 4th ed. © C. Pass, B. Lowes, L. Davies 2005

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The literature about liquidity traps and their international contagion is vast.

International headwinds and the effectiveness of Monetary Policy

All of this speaks to the impotence of central banks to jump-start aggregate demand in balance-sheet-constrained economies that have fallen into 1930s-style "liquidity traps."

A major turning point for central banking

Yetman, "Capital Controls, Global Liquidity Traps and the International Policy Trilemma," NBER Working Paper No.

International finance and macroeconomics

In their efforts to fight inflation, central banks keep interest rates high, which effectively created liquidity traps in these economies.

Arqaam Capital to expand into sub-Saharan and East Africa nations

Australian author Dudley Skelley presents Let's Begin Again for the New Millennium, an anthology of 21 socially conscious poems about potential solutions to human problems - especially liquidity traps (scarcity of credit) and environmental issues.

Bethany's Bookshelf

--(2011a) "Liquidity Traps, Once Again." New York Times (18 March).

What should a central bank (not) do?

I don't wish to leave the impression that Congdon has completely overlooked the problems raised by liquidity traps. He discusses ideas such as buying longer-term securities, whose yields have not fallen to zero.

Money's masterminds

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:

Thirst for debt

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.

The macroeconomics of financial crises: how risk premiums and liquidity traps affect policy options

Goodfriend (2000) and Buiter and Panigirtzoglou (2003) have revived an old proposal by Silvio Gesell for the government to tax money, effectively removing the lower bound on interest rates and therefore eliminating the possibility of liquidity traps.

Interpreting the unconventional U.S. monetary policy of 2007-09

This problem is sometimes referred to as a "liquidity trap." 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.

Financial turmoil: federal reserve policy responses

The government will strive to ease financial distress of SMEs in order to protect viable enterprises from falling into liquidity traps. Efforts will also be made to alleviate burden on households, by lowering interest rates and strengthening financial support.