Thursday, 15 March 2018

Liquidity trap - meaning & preference

liquidity trap

A liquidity trap occurs when interest rates are low/zero failed to encourage consumer spending and monetary policy becomes ineffective. In this situation, even the increase in the money supply could fail to increase spending because interest rates can no longer effect further.

A liquidity trap means the consumer preference for liquid assets (cash) is greater than the rate at which the amount of money developing. So any efforts by policy makers to get the individual to have a non-liquid assets in the form of consumption by increasing the money supply will not work. Or in the simple sense of Community preference to hold the asset wealth in the form of cash greater than store it in the form of savings. So no matter how much the magnitude of interest rate raised by doing the contraction monetary policy will have no effect on the economy of the country.

Based on the fact that there is a macro-economy has long been managed by changing interest rates. So it will be pretty cause problems for policy makers when experienced situations where their main policy tool is no longer adequate.

If the depiction IS-LM curves which is a picture of the balance between market goods and money or real sector and monetary sectors then the case is shown with a horizontal curve of the LM. LM curve is horizontal because the demand for money is perfectly elastic against interest rate. In such a case the monetary policy ineffective, rather fiscal policy will be very effective, because the shift to the right of the curve IS a curve along a horizontal LM will increase income or output without affecting interest rates.

Why Is There A Liquidity Trap?

Expectations of deflation. 

If society in a country expects will happen in the future there is deflation (price drop) real interest rate then it could be quite high even if the nominal interest rate is zero.-If prices fall 2% per year, then kept the money cash in your hands means the value of your money will increase. The difficulty in having a negative nominal interest rate (bank pays you to borrow money). There have been attempts to create a negative interest rate (e.g. destroy money in circulation but in practice rarely implemented.

Preference for savings. Credit Crunch. 

Liquidity Trap occurs during periods of recession and bleak economic prospects. Consumers, companies and banks are pessimistic about the future, so they are more careful to increase savings and it is difficult to exclude the income to spend. The rise in the savings ratio means spending fell. Moreover, in recessions banks far more reluctant to lend. In addition, cuts in the base rate to 0% not likely translate into lower interest rates of bank loans as banks just don't want to lend.

The Bank lost a large amount of money in buying the subprime debt that failed. Therefore, they are trying to repair their balance sheets. They are reluctant to lend so even if companies and consumers wishing to take advantage of low interest rates, the bank would not lend them money.

Reluctance to have bonds. If the interest rate is zero, investors will expect interest rates go up when. If interest rates rise, bond prices fall (see: reverse relationship between bond prices and bond yield ) therefore, investors would rather keep cash savings from bonds continued.

What can be solution for liquidity trap????


When interest rates decrease policy seems to have little or no impact against the aggregate demand, then the economy may experience a liquidity trap. When interest rates close to zero as in the United Kingdom, the United States and in the Euro zone, people may expect little or no real rate of investment return their finances, they can choose not only to hoard their cash rather than invest it. This led to a decrease in money circulation velocity and mean that expansionary monetary policy seems to be helpless. 

If monetary policy is not effective in stimulating demand, the solution may be to use fiscal policy or actions of such unconventional quantitative easing as a means of kick-start and query output in the economy is mired in a slump.


Rising inflation can also help! Due to the inflation higher could generate real interest rate becomes negative and ultimately stimulating the expansion of household and corporate spending.


In a liquidity trap, fiscal policy could become more important as a tool for example demand-management running larger budget deficits to increase demand and boost the money supply.


There is also pressure on the central bank to supply financial market with extra liquidity to encourage them to make loans to one another again and increase the flow of funds available to borrowers.

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