Liquidity Trap
About Liquidity Trap:
- A liquidity trap is an adverse economic situation that can occur when consumers and investors hoard cash rather than spending or investing it even when interest rates are low, stymying efforts by economic policymakers to stimulate economic growth.
- The term was first used by economist John Maynard Keynes, who defined a liquidity trap as a condition that can occur when interest rates fall so low that most people prefer to let cash sit rather than put money into bonds and other debt instruments.
- The effect, Keynes said, is to leave monetary policymakers powerless to stimulate growth by increasing the money supply or lowering the interest rate further.
- A liquidity trap may develop when consumers and investors keep their cash in checking and savings accounts because they believe interest rates will soon rise.
- That would make bond prices fall, and make them a less attractive option.
Features of liquidity trap:
- Central banks like the Federal Reserve force interest rates lower in order to encourage spending and increase economic activity.
- A liquidity trap occurs when interest rates are very low, yet consumers prefer to hoard cash rather than spend or invest their money in higher-yielding bonds or other investments.
- In such cases, the main tool used by the central bank has failed to be effective.
- A leading cause of this syndrome is fear of economic troubles ahead, whether personal or general.
- The effects of a liquidity trap aren’t limited to the bond market. Consumers spend less on goods and services as well.
The following are the key characteristics of a liquidity trap:
- Very low interest rates (at or close to 0%)
- Economic recession
- High personal savings levels
- Low inflation or deflation
- Ineffective expansionary monetary policy
Syllabus: Prelims; Economy
