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
If you do not believe we are in a liquidity trap
, remember the
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