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 ?
If IS cuts LM in the liquidity trap region, income changes will not affect interest rates and the earlier presented models hold.
First observed by John Maynard Keynes during the Great Depression of the 1930s, the liquidity trap describes a situation in which policy interest rates, having reached the zero bound, are unable to stimulate chronically deficient aggregate demand.
The main focus of my research for nearly two decades has been macroeconomic policy during periods when the central bank has cut the short-term nominal interest rate to zero, periods that are often referred to as exhibiting a liquidity trap.
The latest country to join the party was Japan, which has been struggling with the ineffective impact of expansionary monetary policy for more than two decades, a concept known as the liquidity trap.
In fact, it is strikingly reminiscent of the so-called liquidity trap of the 1930s, when central banks were also "pushing on a string.
When the economy is in a liquidity trap - when demand is deficient, prices are stagnant or falling, and interest rates approach zero - normal macroeconomic logic goes out the window.
If the holding of cash is now penalised by negative interest rates, it could be possible to escape from the liquidity trap by encouraging banks to lend, companies to invest and consumers to spend.
This calls for running a diversified portfolio incorporating less-correlated strategies, determining the true amount of illiquidity that one can accept in order to take advantage of time arbitrage and avoid the liquidity trap that I wrote about in my previous column, and picking up the premium from true active management of assets.
It also shrinks overall demand, which is fine when the economy is overheated, but devastating when the economy is depressed and a liquidity trap (Exhibit B: the eurozone again) prevents monetary policy from doing the heavy lifting.
Analysts also show concern over a liquidity trap where corporate investment and housing consumption fail to increase despite abundant liquidity in the market.
Emerging market surpluses have relatively declined * A glut of savings and excess of savings over investment are very similar diagnosis Is this a classic liquidity trap (Krugman)?