Liquidity Trap

A liquidity trap is a macroeconomic condition in which injecting additional money and liquidity into an economy exerts very little impact on overall price levels, output, or employment. It is a macroeconomic phenomenon, meaning that it applies to the economy as a whole and not to industries individually. Only an economy at a low point in a business cycle is at risk of developing a liquidity trap. During a recession, a liquidity trap can become a major hindrance to economic recovery, considerably complicating the task of designing an effective economic policy.

The liquidity trap at first seems more of a puzzle than a trap. It seems paradoxical that the money stock can grow without commiserate growth in spending. Theories of inflation assume that money stock growth does lead to comparable growth in spending, and the growth in spending drives inflation. Only economies experiencing deflation or near deflation seem to be at risk of developing a liquidity trap.

A liquidity trap becomes possible because money, particularly bank balances, can act as a substitute for stocks and bonds, and may even become an attractive substitute if interest rates drop to very low levels. Money pays little or no interest, but it is the most liquid of all financial assets. Liquidity confers certain advantages. It puts one in a position to exploit speculative opportunities or handle financial emergencies. To offset the advantages of liquidity, stocks and bonds pay dividends and higher interest. The danger of a liquidity trap occurs when interest rates reach very low levels, probably lower than 1 percent. Unusually low interest rates of this order occurred in the United States during the 1930s, and again in Japan in the 1990s. Extremely low interest rates, coupled with fear of deflation, makes bank balances a highly attractive financial asset compared to much less liquid stocks and bonds. Low interest rates involve the expectation that interest rates will be higher in the future. Investors do not want to lock in a low interest rate by purchasing longer term financial assets when interest rates are low.

The practical significance of a liquidity trap is that it leaves the monetary authority powerless to stimulate the economy by increasing the money supply. The main ingredient of a monetary stimulus is the purchase of government bonds with newly printed money. Called “open-market operations,” this action makes the bond market more of a seller’s market, meaning bond sellers can sell bonds at lower expected yields. In other words, interest rates fall. In a liquidity trap, the preference for holding bank balances over bonds becomes so strong that open-market operations can no longer reduce interest rates. Falling interest rates no longer accompany above average growth in the money supply.

As a recession unfolds, the market for used capital goods is likely to see severe deflation, which will undercut the prices of new capital goods. Businesses become hesitant to purchase capital goods if they come to expect that capital goods can be purchased at lower prices in the future. Falling demand for finished goods further undermines the willingness to purchase capital goods. With the liquidity trap acting as a floor under interest rates, openmarket operations cannot push interest rates low enough to stem the tide of falling investment spending. The economy sinks deeper into recession.

The cure for a liquidity trap involves a high level of government deficit spending to compensate for the absence of business investment spending. In the 1990s, the Japanese government baulked at enlarging the public debt on the scale needed to lift Japan out of the liquidity trap. The Japanese economy languished in recession during much of the 1990s.