Liquidity Trap

What is Liquidity Trap?

The liquidity trap is a scenario where the interest rates fall and yet the rate of savings goes high, which tends to bring about ineffectiveness to the objective of expansionary monetary policyExpansionary Monetary PolicyThe central bank uses expansionary monetary policy to increase the supply of money while lowering the interest rate and increasing demand. This is done to boost a country's economy.read more to increase the money supply. In this situation, people prefer holding cash rather than bearing a debt leading to virtual omission of liquidity from the market.

Causes of the Liquidity Trap

• The liquidity trap is generally seen after a recessionary period. People are generally in a savings tendency during those times and prefer to hold cash rather than taking debt.
• It basically occurs when even though there is a supply of money in the market it fails to increase the amount of spending and investment.
• There is a situation of very low-interest rates in the market and even though policymakers want common people to hold illiquid assets by increasing the supply of money, the scenario fails to attract consumers.

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Example of the Liquidity Trap

A classic example of liquidity trap can be global recessionGlobal RecessionGlobal recession refers to a condition when the countries across the globe experience an economic downturn for an extended period. It is a form of synchronized economic downfall encountered by the various interrelated economies throughout the world.read more which the US faced during the period of 2008-10. When the economy failed as whole central banks in the united states adapted to almost zero interest rate short term lending policy to enhance the liquidity in the market since people were holding their cash close to themselves fearing the global depression.

Even though the monetary base was tripled during those times but even lending as such interest rates did not produce any significant results on the domestic price indices or the economy as a whole thus creating a liquidity trap.

Top 5 Reasons for the Liquidity Trap

#1 – Affinity towards Saving

Generally, during the recessionary period, people tend to hold cash close to them. This habit increases the saving rate but decreases the spending rate. On account of being pessimistic about future conditions, they use this policy as a safety measure. Furthermore, banks are also reluctant to lend even after cutting the base rate as close to zero, the effect does not get translated to other lower commercial banks.

#2 – Deflation Expectation

If consumers expect a fall in prices the real rate of interestReal Rate Of InterestReal interest rates are interest rates calculated after taking inflation into account. It is a means of obtaining inflation-adjusted returns on various deposits, loans, and advances, and thus reflect the real cost of funds to the borrower. read more can climb high even though the nominal rate is close to zero. The difficulty is the creation of a negative nominal interest rateNominal Interest RateNominal Interest rate refers to the interest rate without the adjustment of inflation. It is a short term interest rate which is used by the central banks to issue loans.read more i.e. a rare condition where banks would pay us to borrow us so that the spending increases.

#3 – Credit Crunch

Banks become reluctant to lend during those phases even if consumers want to take advantage of the low rate of interest because they already suffer a huge loss in buying back defaulted debts and thus move into a stage of cleaning their balance sheetTheir Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more.

#4 – Decline in Demand of Bonds

During phases of a liquidity trap, interest rates go down to almost zero with the hope that it will rise after a period. When the rate of interest goes high again the price of bondPrice Of BondThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read more falls. Thus, investors feel that it is preferable to hold cash than bonds.

#5 – Demand for Investment Goes Down

Firms do not find lower interest rates appealing because during this phase the firms don’t prefer to invest because the demand stands very low.

Advantages of the Liquidity Trap

• It creates a market of cheap borrowing option and thus this can be phase to avail cheap loans for borrowing.
• It forces the policymakers to audit existing monetary policiesMonetary PoliciesMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more and come out with newer ideas to match the current scenario.
• It inculcates the habit of saving among consumers.

Disadvantages of the Liquidity Trap

• The liquidity trap generally occurs after a recession. This can further enhance the problem of recession even further unintentionally rather than solving it.
• The phase is such that the central bank loses one of its prime powers to tweak the economy with the interest rate factor and stimulate growth.
• The risk of coming out of the liquidity trap is inflation which follows it. Dues to too much money available in the economy.
• It gives rise to unemployment as companies adapt to layoffs costly resources and hire other resources at cheaper prices. It also declines to the lowering down of wages where people are further forced to compromise with goods and services.
• When interest rates go abnormally low, banks lack deposit base their income from loans is not that encouraging. Thus, they become reluctant to give loans.
• Insurance companies are greatly affected because of low-interest rates. They rely on interest-based returns on the sum they receive from their customers as premiums to cover the liabilities which further may lead to an increase in insurance premiums.

Top 5 Solutions of Liquidity Trap

• The interest rate offered by the central bank can play a key role. Increment in the rate of interest of short-term borrowing stimulates people to invest instead of hoarding it. Higher long-term rates stimulate banks to lend since they will get a better return. This enhances the flow of money.
• The price declines to the lowest point that people are forced to shop more. It is applicable for both durable goods and assets like stocks. Investors start buying again because of the fact that they can hold onto the asset long enough to overcome the phase.
• Increment in government spending can create confidence that the economic growth will be supported by the lender. It helps in the creation of jobs, eradicating unemployment and hoarding of cash.
• Financial restructuring and innovative ideas which can help in setting up a totally new market and come out of the existing trap.
• Global cooperation can be one of the solutions where two or more nations with excess and deficit of cash can come together and help in each other’s problems to reach a mutual balance.

Important Points

• The nominal rate close to zero gives rise to the liquidity trap.
• Recession or global depression is the prime reason for the liquidity trap.
• Monetary policy becomes ineffective.
• The unemployment rate rises with basic wages coming down.

Conclusion

A liquidity trap takes place when people curtail their spending habits and go on a saving mode or invest even when interest rates are low. The central bank fails to boost the national economy because on account of the lack of demand. If it is not controlled initially it can lead to deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more. One key example of the liquidity trap is Japan’s national economy.

Recommended Articles

This has been a guide to what is the liquidity trap and its definition. Here we discuss reasons and examples of liquidity trap along with its solutions. We also discuss the advantages and disadvantages. You can more about finance from the following articles –

• Liquidation Preference
• What is Abnormal Return?
• Contractionary Monetary Policy
• Expansionary Policy Tools