Liquidity Trap

21 Dec


From theoretical curiosity to a practical reality, liquidity trap has come to haunt the world’s largest economy with questions being raised as to whether US will also experience a “lost decade”, much like the Japanese, before things turn normal again. So while the specter of the liquidity trap is raging high, let’s try and understand what this phenomenon is all about.

With the Fed lowering the benchmark federal funds rate to nearly zero, you must have increasingly come across the term ‘liquidity trap’, describing the present economic condition in the US. In this article, we set the record straight and explain in lucid terms what liquidity trap is all about. If you really want to hear from the horse’s mouth what a liquidity trap is, then you should talk to John, (that would be John Maynard Keynes). Keynes had introduced the concept of liquidity trap in his description of the conditions prevailing in the US in the 1930s (the era of the Great Depression). Since a high tea with Keynes would not be possible, you could probably talk to some Japanese central bankers. After all, the Japanese economy has been diagnosed with a liquidity trap condition since the mid 1990s.

Japan has been a depressing yet fascinating story. Since 1990, the Japanese economy has been characterized by a secular recession. Economists of different clan, ranging from classical to Keynesians to neo classical, have studied the Japanese economy and have prescribed remedial measures, but to no avail. Lars E.O. Svensson (2003) in his paper Escaping From A Liquidity Trap And Deflation: The Foolproof Way And Others writes,

Expansive fiscal policy, with a big fiscal deficit, has not ended stagnation in Japan but has lead to huge national debt, close to 150 percent of GDP at the end of 2001 and still increasing. With regard to monetary policy, Bank of Japan lowered the interest rate to zero and kept it there from February 1999 to August 2000, and again from March 2001 until now. From March 2001, after long indecisiveness, it also attempted a so-called “quantitative easing,” a substantial expansion of the monetary base. During two years up to the spring of 2003, the monetary base was increased by about 50 percent. But these steps were not sufficient to induce a recovery.

So, what exactly is a liquidity trap? In a nutshell, liquidity trap refers to a condition when the monetary policy (policies which affect the money supply in an economy) becomes completely ineffective. Let us picture an economy suffering from stagnation in its GDP growth with deflating prices. To stimulate the economy, the central bank lowers the nominal interest rates in the economy. Lower interest rates will lead to cheaper credit, which will boost aggregate demand via increased investment demand and consumer spending. Let’s say the nominal interest rate was initially at 4 per cent which is then gradually reduced. The severe recessionary tendencies prompt the central bank in reducing the nominal interest rates all the way to zero per cent. A further reduction in the interest rates would imply a negative nominal interest rate, which violates the assumption of time preference of money, and hence is not a practical possibility. (Simply put, the nominal interest rate cannot be negative as that would mean that if you borrow Rs.100, at maturity, you would have to return back less than Rs.100, so, no sane lender will lend when interest rates are negative.) Thus, zero acts as a zero lower bound (ZLB) constraint for nominal interest rates.

If you would notice, we have used the word “nominal” to describe the interest rates. Though the nominal interest rates cannot be negative, the real rate of interest can be negative. Real interest rate is defined as,

Real Interest Rate = Nominal Interest Rate – Inflation

So if the nominal interest rate is say 5 per cent and the inflation rate is around 7 per cent, then the real interest rate will be -2. It should be noted that consumption and investment decisions are a function of the real interest rates and not nominal interest rates.

With the above base, let’s delve deeper into the world of liquidity trap. A liquidity trap situation is characterized when the nominal interest rate hits the zero lower bound constraint, and yet the real interest rate remains high. This happens when the economy is suffering from deflation which is not expected to change in the near term. Even if the nominal interest rate is held at zero, in case the price level in the economy is falling at the rate of 2 per cent, the real interest rate works out to be,

Real Interest Rate = 0 – (-2) = 2 per cent

So the catch is that it may appear that the interest rate in the economy is very low, but because of deflationary expectations in the economy, the perceived real interest rate is still high, and thus even a zero nominal interest rate may fail to stimulate aggregate demand in the economy via increased investments and consumer spending. This is why in a liquidity trap, monetary policy becomes ineffective and even a zero interest rate policy (ZIRP) is ineffective in gaining traction on the economy.

It would be interesting to note that in a liquidity trap, with very low nominal interest rates, open market operations, perhaps the most important tool for conducting monetary policy, itself breaks down. Open market operation refers to the buying and selling of government bonds by the central bank of a country. When the central bank buys government bonds in the market, it increases the money supply in the economy (as money is put into the hands of the people previously holding the bonds), and when it sells government bonds, it reduces the money supply (as people previously holding money exchange it for bonds). Now, when interest rates are zero, people would prefer to hold money (which has the added advantage of liquidity) over bonds. Thus open market operations emerge as a very important tool for changing the money supply and hence conducting monetary policy. In a liquidity trap however, the demand for money becomes infinite, i.e. money demand becomes perfectly elastic, and hence come what may, people will only prefer to hold money and not bonds. Thus the policy of trading in bonds to influence money supply breaks down.

(The discerning might question the above logic saying that even if the nominal interest rates are zero, there might still be some demand for bonds because real interest rate is strictly positive. A valid point. However, even if the real interest rates are positive, investing in bonds in a liquidity trap will entail a capital loss as going forward, because of the zero lower bound constraint, the only movement future nominal interest rates will show is up, and given the inverse relationship between bond prices and interest rates, bond prices will fall in future.)

A liquidity trap is potentially dangerous as it leads to a breakdown in the transmission mechanism. Generally, a lower signaling interest rate set by the central bank lowers the overall level of interest rate in the economy. Banks lend more on the back of increased demand for credit, both for investment purposes and for consumer spending (like home loans, car loans, etc), which leads to increased aggregate demand. This is how monetary policy works. In a liquidity trap however, the story is different. Recall that a liquidity trap occurs in a situation of recession in GDP growth and deflation, when interest rates are lowered to fight the slowdown. The depressing economic scenario in which a liquidity trap occurs is also accompanied by negative business and consumer sentiments. At such times, which is generally a fall out of some economic crisis, even if liquidity is made available, economic agents may be too risk averse to use the liquidity and may simply sit on such liquidity (i.e. hoard money). Banks may refuse to lend, either on account of increased risk aversion or on account of reduced incentive to lend as interest rates are near zero. Even if credit is supplied, with prices showing a downturn, entrepreneurs will refuse to invest in production. Even if the government increases the money supply through deficit financing (printing of money), people just sit on reserves of money and hoard it. This led Milton Friedman to suggest that a way out of a liquidity trap would be to stash money in the hands of the people and ask them to spend it. Such an approach is called ‘helicopter money’ as it brings up images of the central banker flying in the air and dropping bundles of cash at the people (see image below).


Central bankers are petrified of a liquidity trap as shooing it away requires managing expectations in an economy. If we recall the root cause of a liquidity trap, it is high real interest rates in the face of zero nominal interest rates. Lowering the real interest rate in the economy when the nominal interest rate has already hit the zero lower bound would require stoking up inflationary expectations in the economy. It is only when sufficient inflationary expectations in the economy have been generated that the perceived real interest rate will come down and the transmission mechanism will work. This is not an easy task for a central bank which has throughout its history sought to build a strong reputation for fighting inflation in order to enhance its credibility, and certainly not an easy task for ‘inflation hawks’ like the Japanese Central Bank and the Federal Reserve.

Economists have come up with different suggestions for stoking inflationary expectations in the economy, like following a price target path, commitment to inflation, increasing money supply further, currency depreciation, aggressive fiscal policy through government borrowing, etc.

However, as the Japanese case would suggest, shaping expectations in an economy is not an easy task as it would depend on the credibility of any announcement coming from the central bank. If people believe that as soon as inflation rears it ugly head and the recession tendencies wane, the accommodating monetary policy will be reversed by the central bank, then the remedial measures to escape from a liquidity trap will be ineffective. Only when the central bank declares that monetary easing will persist in the near future, even if inflation turns positive, and people believe in the declaration, will the policy be effective in defeating a liquidity trap. Declaring is easy. Making people believe is the difficult part.

In the Japanese case, the loose monetary policy directed towards generating inflationary expectations was ineffective as the exchange rate was not allowed to depreciate simultaneously (an inflationary policy should manifest itself in an exchange rate depreciation as it lowers the value of the domestic currency). A depreciating yen along with monetary easing would have given much more credibility to the policy for stoking inflationary expectations in the Japanese economy. However, the lack of depreciation in the domestic exchange rate gave away the fact that the Japanese central bank was still apprehensive of giving inflation a free hand in the economy over a medium term.

According to Paul Krugman, a central bank caught in the vortex of a liquidity trap has to have an explicit mandate to behave ‘irresponsibly’ by generating inflation in the economy. And it should take all steps necessary to prove the point that it is irresponsible. Guess it’s time to add a new chapter on the functions of a central bank…

Published by Ravi Saraogi


9 Responses to “Liquidity Trap”

  1. somya December 22, 2008 at 5:50 am #

    A very complex system explained in an unbelievably simple-to-understand article. It’s a tour through our macro book guys and that too in a nutshell…A must read for all…

  2. Arindam December 22, 2008 at 3:32 pm #

    Nice read 🙂

    You should read Mankiw’s blog – he’s part of the economic counsel for Bush. He and Krugman keep having fights on their blogs. This was the topic for argument recently.

  3. Kenny O'Neil December 23, 2008 at 12:30 am #

    If people are out of cash and whatever cash they’ve had on hand is draining rapidly due to diminishing income or missing income…. If banks have tightened their lending standards so high that it is difficult for most to revive any sort of line of credit that had been cut short by banks… If people’s credit scores on the whole are lower due to missed, backed up payments and now have a harder time getting the loan under old loan standards… Then either we just ‘bite the bullet’ and let things fall apart and settle ‘naturally’ or we get really socialistic and have government pass laws and enact much more flexible rules of lending or simply take over the banks (yikes!) and get liquidity going again. In the mean time every citizen needs to start thinking outside the box on how they could start earning extra money outside of the traditional ‘job’.

  4. informedinvestors December 24, 2008 at 10:51 am #

    Yes jana.. I did indeed read up abt it.. Both eventually advocate the same policy for fighting a liquidity trap – inflationary expectations.

  5. informedinvestors December 24, 2008 at 10:51 am #

    Thank you very much 🙂

  6. somya January 4, 2009 at 4:25 pm #

    someone is getting famous….. 😉 lot of discussion going on about your recent post haan??ehhh….sorry Dr….i know you like to keep your blog professional but i just couldn’t help commenting about this…long way to go boss….wish you the best…three cheers to informed (and the not-so-informed) investor’s!!!!!!happy new year!! 🙂

  7. informedinvestors January 12, 2009 at 8:39 am #

    with ur blessings, this blog can achieve more…. 😉 thank u thank u for ur wishes… happy new year to u too !!!!!

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  1. Stocks and Bonds » Blog Archive » Liquidity Trap « Informed Investors’S - December 22, 2008

    […] Generally, a lower signaling interest rate set by the central bank lowers the overall level of interest rate in the economy. Banks lend more on the back of increased demand for credit, both for investment purposes and for consumer …[Continue Reading] […]

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