Revision: The Liquidity Trap

A break down in monetary policy

When cuts in policy interest rates seem to have little or no impact on aggregate demand, then the economy can experience a liquidity trap. When interest rates are close to zero as they are in the UK, the USA and in the Euro Zone, people may expect little or no real rate of return on their financial investments, they may choose instead simply to hoard cash rather than investing it. This causes a fall in the velocity of circulation of money and means that an expansionary monetary policy appears to become impotent. If monetary policy is ineffective in stimulating demand, the solution may be to use fiscal policy or unconventional measures such as quantitative easing as a means of kick-starting demand and output in an economy mired in a slump.

Monetising the economy One possible solution is to seek to “monetise the economy” by large scale buy-backs of government debt by the central bank to inject cash or liquidity into the economy. This was an option considered by the Japanese government during their deflationary recession in the late 1990s. And it has hit the news again in 2009 with the Bank of England engaging in quantitative easing with an initial scheme to buy-back up to £100bn of government securities. For the latest on this click this link.

“The liquidity trap - a situation in which conventional monetary policy loses all traction” (Paul Krugman, March 2008)

In normal circumstances, monetary policy can be a powerful instrument in managing aggregate demand, output and inflationary pressures and smoothing the impact of external shocks. But on occasions, monetary policy can become ineffective. A liquidity trap occurs when the nominal (money) interest rate is close or equal to zero, and the central banks find that they have run out of room to stimulate demand during a slowdown or a recession.

Why does the liquidity trap effect happen?

(1) Expectations of future interest rate movements: Consumers and businesses have expectations of what constitutes a normal rate of interest.
Consider a situation where a central bank has slashed interest rates to abnormally low levels perhaps because they fear a recession or to reduce the threat of price deflation.

When interest rates are exceptionally low, people may downgrade their forecasts for the returns likely on investments such as property, stocks and bonds. The low interest rates may also tell them that something is badly wrong in the economy and as a result, they may choose to hoard cash or save their income in high interest-bearing accounts. The key is that they think that the next move in interest rates is likely to be upwards because interest rates are rarely at abnormally low levels.
The expectation of interest rates moving higher may cause people to postpone consumption even though the central bank is trying to stimulate spending through a low interest rate policy.

(2) Credit crunches: When there has been a collapse in confidence in the financial sector leading to a credit crunch, banks, building societies and other lenders may decide to cut the amount that they are (i) prepared to lend to each other and (ii) prepared to lend to personal and corporate borrowers.
A fall in the supply of lending raises inter-bank interest rates and creates a disconnection between official policy interest rates and the cost of borrowing in wholesale and retail credit markets. We have seen some evidence of this in the UK during 2008-09 with the Bank of England cutting interest rates but at the same time, the cost of overdrafts and other forms of consumer credit have risen (and mortgage loans have become much harder to get).

How to overcome a liquidity trap effect?

- In a liquidity trap, fiscal policy may become more important as an instrument of demand-management e.g. running a larger budget deficit to boost demand and increase the money supply.

- There is also pressure on central banks to supply the financial markets with extra liquidity to encourage them to lend to each other again and increase the flow of funds available for borrowers

- A rise in inflation can also help! Because higher inflation can lead to real interest rates being negative and eventually stimulating an expansion of household and corporate spending.

- The central bank may want to establish in people’s minds that they will keep real interest rates low as a way of altering expectations.

There is evidence that short term changes in policy interest rates have become less effective in boosting confidence and demand. But keep in mind that the economic circumstances of this recession are quite different from previous slumps. It may be that the time lags between policy decisions and their effects has lengthened. Or that for policy to work, it needs to be co-ordinated between a group of countries. This is because of the increasingly inter-connected nature of macroeconomic activity.