Aliquidity trap is a situation, described inKeynesian economics, in which, "after therate of interest has fallen to a certain level,liquidity preference may become virtually absolute in the sense that almost everyone prefers holdingcash rather than holding a debt (financial instrument) which yields so low a rate of interest."[1]
Negative natural interest rates and a zero lower bound are necessary conditions of a liquidity trap.[2] Temporary economic disruption (e.g. banking crises, excessive debt accumulation) and structural factors (e.g. demographic decline, inequality) can produce negative natural interest rates.[2] Credible monetary policy can overcome liquidity traps.[2]
A liquidity trap is caused when people hold cash because theyexpect an adverse event such asdeflation, insufficientaggregate demand, orwar. Among the characteristics of a liquidity trap are interest rates that are close tozero lower bound and changes in themoney supply that fail to translate into changes ininflation.[3]
The Great Depression, the Great Recession and Japan'sLost Decades are examples of liquidity traps.[2]
John Maynard Keynes, in his 1936General Theory,[1] wrote the following:
There is the possibility...that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto.
This concept ofmonetary policy's potential impotence[4] was further worked out in the works of British economistJohn Hicks,[5] who published theIS–LM model representing Keynes's system.[note 1]Nobel laureatePaul Krugman, in his work on monetary policy, follows the formulations of Hicks:[note 2]
A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injectingmonetary base into the economy has no effect, because [monetary] base andbonds are viewed by theprivate sector as perfect substitutes.[3]
In a liquidity trap, people are indifferent between bonds and cash because the rates of interest bothfinancial instruments provide to their holder is practically equal: The interest on cash is zero and the interest on bonds is near-zero. Hence, the central bank cannot affect the interest rate any more (through augmenting themonetary base) and has lost control over it.[6]
In Keynes' description of a liquidity trap, people simply do not want to hold bonds and prefer other, more-liquid forms of money instead. Because of this preference, after converting bonds into cash,[note 3] this causes an incidental but significant decrease to the bonds' prices and a subsequent increase to their yields. However, people prefer cash no matter how high these yields are or how high the central bank sets the bond's rates (yields).[7]
Post-Keynesian economistHyman Minsky posited[8] that "after a debtdeflation that induces a deepdepression, an increase in themoney supply with a fixed head count of other[financial] assets may not lead to a rise in the price of other assets." This naturally causes interest rates on assets that are not considered "almost perfectly liquid" to rise. In which case, as Minsky had stated elsewhere,[9]
The view that the liquidity-preference function is a demand-for-money relation permits the introduction of the idea that in appropriate circumstances the demand for money may be infinitelyelastic with respect to variations in the interest rate… The liquidity trap presumably dominates in the immediate aftermath of arecession orfinancial crisis.
In the wake of theKeynesian Revolution in the 1930s and 1940s, variousneoclassical economists sought to minimize the effect of liquidity-trap conditions.Don Patinkin[10] andLloyd Metzler[11] invoked the existence of the so-called "Pigou effect",[12] in which the stock of real money balances is ostensibly an argument of theaggregate demand function for goods, so that themoney stock would directly affect the "investment saving" curve inIS/LM analysis.Monetary policy would thus be able to stimulate the economy even when there is a liquidity trap.
Monetarists, most notablyMilton Friedman,Anna Schwartz,Karl Brunner,Allan Meltzer and others, strongly condemned any notion of a "trap" that did not feature an environment of a zero, or near-zero, interest rate across the whole spectrum of interest rates, i.e. both short- and long-term debt of the government and the private sector. In their view, any interest rate different from zero along the yield curve is a sufficient condition to eliminate the possibility of the presence of a liquidity trap.[note 4]
In recent times, when the Japanese economyfell into a period of prolongedstagnation, despite near-zero interest rates, the concept of a liquidity trap returned to prominence.[13] Keynes's formulation of a liquidity trap refers to the existence of a horizontaldemand-curve for money at some positive level of interest rates; yet, the liquidity trap invoked in the 1990s referred merely to the presence ofzero or near-zero interest-rates policies (ZIRP), the assertion being that interest rates could not fall below zero.[note 5] Some economists, such asNicholas Crafts, have suggested a policy ofinflation-targeting (by acentral bank that is independent of the government) at times of prolonged, very low, nominal interest-rates, in order to avoid a liquidity trap or escape from it.[14]
SomeAustrian School economists, such as those of theLudwig von Mises Institute, reject Keynes' theory of liquidity preference altogether. They argue that lack of domestic investment during periods of low interest-rates is the result of previousmalinvestment andtime preferences rather thanliquidity preference.[15]Chicago school economists remain critical of the notion of liquidity traps.[16]
Keynesian economists, like Brad DeLong andSimon Wren-Lewis, maintain that the economy continues to operate within theIS-LM model, albeit an "updated" one,[17] and the rules have "simply changed."[18]
During the2008 financial crisis, as short-term interest rates for the various central banks in the United States and Europe moved close to zero, economists such asPaul Krugman argued that much of the developed world, including the United States, Europe, and Japan, was in a liquidity trap.[19] He noted that tripling of themonetary base in the US between 2008 and 2011 failed to produce any significant effect on domestic price indices or dollar-denominated commodity prices,[20] a notion supported by others, such asScott Sumner.[21]
U.S. Federal Reserve economists assert that the liquidity trap can explain low inflation in periods of vastly increased central bank money supply. Based on experience $3.5 trillion ofquantitative easing from 2009–2013, the hypothesis is that investors hoard and do not spend the increased money because theopportunity cost of holding cash (namely the interest forgone) is zero when the nominal interest rate is zero.[22] This hoarding effect is purported to have reduced consequential inflation to half of what would be expected directly from the increase in the money supply, based on statistics from the expansive years. They further assert that the liquidity trap is possible only when the economy is in deeprecession.
Modest inflation during theCOVID-19 crisis in 2020, despite unprecedented monetary stimulus and expansion, was similarly ascribed to hoarding of cash.
Post-Keynesians respond[23] that the confusion by "mainstream economists" between conditions of a liquidity trap, as defined by Keynes and in the Post-Keynesian framework, and conditions of near-zero or zero interest rates, is intentional and ideologically motivated in ostensibly attempting to support monetary over fiscal policies. They argue that,quantitative easing programs in the United States, and elsewhere, caused the prices of financial assets to rise across the board andinterest rates to fall; yet, a liquidity trap cannot exist, according to the Keynesian definition, unless the prices on imperfectly safe financial assets are falling and their interest rates are rising.[24] The rise in the monetary base did not affect interest rates or commodity prices.[25]
Taking the precedent of the2008 financial crisis, critics[26] of the mainstream definition of a liquidity trap point out that the central bank of the United States never, effectively, lost control of the interest rate. Whereas the United States did experience a liquidity trap in the period 2009/10, i.e. in "the immediate aftermath" of the crisis,[note 6] the critics of the mainstream definition claim[23] that, after that period, there is no more of any kind of a liquidity trap since government and private-sector bonds are "very much in demand".[7] This goes against Keynes' point as Keynes stated that "almost everyone prefers cash to holding a debt."[1] However, modern finance has the concept ofcash and cash equivalents;Treasuries may in some cases be treated as cash equivalents and not "debt" for liquidity purposes.[27]
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