A liquidity trap is a situation, described in

Keynesian economics Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output ...

, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding

cash In economics, cash is money in the physical form of currency, such as banknotes and coins. In bookkeeping and financial accounting, cash is current assets comprising currency or currency equivalents that can be accessed immediately or near-im ...

rather than holding a debt ( financial instrument) which yields so low a rate of interest." Keynes, John Maynard (1936) '' The General Theory of Employment, Interest and Money'', United Kingdom: Palgrave Macmillan, 2007 edition, A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Among the characteristics of a liquidity trap are interest rates that are close to zero and changes in the

money supply In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circu ...

that fail to translate into changes in the price level. Krugman, Paul R. (1998)
"It's baack: Japan's Slump and the Return of the Liquidity Trap,"
Brookings Papers on Economic Activity

Origin and definition of the term

John Maynard Keynes John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...

, in his 1936 ''General Theory'', 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 of

monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for federal funds, very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money s ...

's potential impotence was further worked out in the works of British economist

John Hicks Sir John Richards Hicks (8 April 1904 – 20 May 1989) was a British economist. He is considered one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economic ...

, Hicks, John R. (1937)
Mr Keynes and the Classics: A Suggested Interpretation
, ''

Econometrica ''Econometrica'' is a peer-reviewed academic journal of economics, publishing articles in many areas of economics, especially econometrics. It is published by Wiley-Blackwell on behalf of the Econometric Society. The current editor-in-chief is ...

'', Vol. 5, No. 2, April 1937, pp. 147-159 who published the IS–LM model representing Keynes's system.The model depicts and tracks the intersection of the " investment– saving" (IS) curve with the " liquidity preference–

" (LM) curve. At the intersection, according to the mainstream, Neo-Keynesian analysis, simultaneous equilibrium occurs in both interest and financial-assets markets Nobel laureate

Paul Krugman Paul Robin Krugman ( ; born February 28, 1953) is an American economist, who is Distinguished Professor of Economics at the Graduate Center of the City University of New York, and a columnist for ''The New York Times''. In 2008, Krugman was t ...

, in his work on monetary policy, follows the formulations of Hicks:Hicks, subsequently and a few years before his passing, repudiated the IS/LM model, describing it as an "impoverished" representation of Keynesian economics. See Hicks (1981)

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: injecting monetary base into the economy has no effect, because onetarybase and
bond Bond or bonds may refer to: Common meanings * Bond (finance), a type of debt security * Bail bond, a commercial third-party guarantor of surety bonds in the United States * Chemical bond, the attraction of atoms, ions or molecules to form chemical ...
s are viewed by the
private sector The private sector is the part of the economy, sometimes referred to as the citizen sector, which is owned by private groups, usually as a means of establishment for profit or non profit, rather than being owned by the government. Employment The ...
as perfect substitutes.

In a liquidity trap, people are indifferent between bonds and cash because the rates of interest both financial 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 the monetary base) and has lost control over it.

Elaboration

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,Whereby "cash" includes both currency and bank accounts, aka M1 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). Pilkington, Philip (2014)
Paul Krugman Does Not Understand the Liquidity Trap
, ''Naked Capitalism''website, 23 July 2014

Post-Keynesian economist Post-Keynesian economics is a school of economic thought with its origins in ''The General Theory'' of John Maynard Keynes, with subsequent development influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor, Sidney W ...

Hyman Minsky Hyman Philip Minsky (September 23, 1919 – October 24, 1996) was an American economist, a professor of economics at Washington University in St. Louis, and a distinguished scholar at the Levy Economics Institute of Bard College. His research ...

posited Minsky, Hyman (1986 008
Stabilizing an Unstable Economy
', 1st edition: Yale University Press, 1986; reprint: McGraw Hill, 2008, that "after a debt deflation that induces a deep depression, an increase in the

with a fixed head count of other inancialassets 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, Minsky, Hyman (1975 008 ''John Maynard Keynes'', McGraw-Hill Professional, New York, 2008,

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 infinitely
elastic Elastic is a word often used to describe or identify certain types of elastomer, elastic used in garments or stretchable fabrics. Elastic may also refer to: Alternative name * Rubber band, ring-shaped band of rubber used to hold objects togethe ...
with respect to variations in the interest rate… The liquidity trap presumably dominates in the immediate aftermath of a great depression or financial crisis.

Historical debate

In the wake of the Keynesian revolution in the 1930s and 1940s, various

neoclassical economists Neoclassical economics is an approach to economics in which the production, consumption and valuation (pricing) of goods and services are observed as driven by the supply and demand model. According to this line of thought, the value of a good ...

sought to minimize the effect of liquidity-trap conditions. Don Patinkin and

Lloyd Metzler Lloyd Appleton Metzler (1913 – 26 October 1980) was an American economist best known for his contributions to international trade theory. He was born in Lost Springs, Kansas in 1913. Although most of his career was spent at the University of ...

invoked the existence of the so-called " Pigou effect", in which the stock of real money balances is ostensibly an argument of the aggregate demand function for goods, so that the

money stock In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circula ...

would directly affect the "investment saving" curve in IS/LM analysis.

Monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for federal funds, very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money s ...

would thus be able to stimulate the economy even when there is a liquidity trap. Monetarists, most notably

Milton Friedman Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...

, 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.See " Monetarism and the liquidity trap In recent times, when the Japanese economy fell into a period of prolonged stagnation, despite near-zero interest rates, the concept of a liquidity trap returned to prominence. Keynes's formulation of a liquidity trap refers to the existence of a horizontal demand-curve for money at some positive level of interest rates; yet, the liquidity trap invoked in the 1990s referred merely to the presence of zero or near-zero interest-rates policies (ZIRP), the assertion being that interest rates could not fall below zero.The assumption being that no one would lend 100 dollars unless they were to get at least 100 dollars back, although we have seen in the 21st century the introduction, without any problem in demand, of negative interest-rates. See e.g.
Why negative interest rates sometimes succeed
by Gemma Tetlow, ''

Financial Times The ''Financial Times'' (''FT'') is a British daily newspaper printed in broadsheet and published digitally that focuses on business and economic current affairs. Based in London, England, the paper is owned by a Japanese holding company, Nik ...

'', 5 September 2016 Some economists, such as Nicholas Crafts, have suggested a policy of

inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduct ...

-targeting (by a

central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a centra ...

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. Some

Austrian School The Austrian School is a heterodox school of economic thought that advocates strict adherence to methodological individualism, the concept that social phenomena result exclusively from the motivations and actions of individuals. Austrian scho ...

economists, such as those of the

Ludwig von Mises Institute Ludwig von Mises Institute for Austrian Economics, or Mises Institute, is a libertarian nonprofit think tank headquartered in Auburn, Alabama, United States. It is named after the Austrian School economist Ludwig von Mises (1881–1973). It ...

, reject Keynes' theory of liquidity preference altogether. They argue that lack of domestic investment during periods of low interest-rates is the result of previous malinvestment and time preferences rather than liquidity preference. Chicago school economists remain critical of the notion of liquidity traps. Keynesian economists, like Brad DeLong and

Simon Wren-Lewis Simon Wren-Lewis is a British economist. He is a professor of economic policy at the Blavatnik School of Government at Oxford University and a Fellow of Merton College. Education Wren-Lewis was educated at Latymer Upper School, Hammersmith; C ...

, maintain that the economy continues to operate within the IS-LM model, albeit an "updated" one, and the rules have "simply changed."

Global financial crises of 2008 and 2020

During the Global Financial Crisis, in the period 2008–2010, as short-term interest rates for the various central banks in the United States and Europe moved close to zero, economists such as

argued that much of the developed world, including the United States, Europe, and Japan, was in a liquidity trap. He noted that tripling of the monetary base in the US between 2008 and 2011 failed to produce any significant effect on domestic price indices or dollar-denominated commodity prices, a notion supported by others, such as

Scott Sumner Scott B. Sumner (born 1955) is an American economist. He is the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University, a Research Fellow at the Independent Institute, and professor who teaches at Bentle ...

. 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 of quantitative easing from 2009–2013, the hypothesis is that investors hoard and do not spend the increased money because the opportunity cost of holding cash (namely the interest forgone) is zero when the nominal interest rate is zero. 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 deep

recession In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various ...

Modest inflation during the

COVID-19 Coronavirus disease 2019 (COVID-19) is a contagious disease caused by a virus, the severe acute respiratory syndrome coronavirus 2 (SARS-CoV-2). The first known case was identified in Wuhan, China, in December 2019. The disease quick ...

crisis in 2020, despite unprecedented monetary stimulus and expansion, was similarly ascribed to hoarding of cash. The M1

(currency and demand deposits and other checkable deposits which pay negligible interest) exploded from $4 trillion to $20 trillion during this period, consistent with the theorized hoarding of a liquidity trap. Post-Keynesians respond 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 and

interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, t ...

s 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. Mitchell, William (2012)
The on-going crisis has nothing to do with a supposed liquidity trap
, 28 June 2012 The rise in the monetary base did not affect interest rates or commodity prices. Taking the precedent of the Global Financial Crisis of 2008, critics 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,During approximately 2009/10, the interest rates on risky financial assets failed to respond to Fed intervention, as demonstrated by the TED spread history. Se
TED rate
for the period 2007/16 the critics of the mainstream definition claim Pilkington, Philip (2013)
What is a Liquidity Trap?
, ''Fixing the economists'' website, 4 July 2013 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". This goes against Keynes' point as Keynes stated that "almost everyone prefers cash to holding a debt." However, modern finance has the concept of

cash and cash equivalents Cash and cash equivalents (CCE) are the most liquid current assets found on a business's balance sheet. Cash equivalents are short-term commitments "with temporarily idle cash and easily convertible into a known cash amount". An investment norma ...

; Treasuries may in some cases be treated as cash equivalents and not "debt" for liquidity purposes.

Origin and definition of the term

Elaboration

Historical debate

Global financial crises of 2008 and 2020

See also

Notes

References

Further reading