The Dynamics of a Liquidity Trap

The term liquidity trap is used in economic theory to describe a situation where interest rates are very low (approaching zero). And the demand for money is completely elastic, which causes the monetary authorities not to lower interest rates further. In these situations monetary policy is rendered useless to stimulate economic activity.

Given this kind of situation the monetary authorities respond by increasing the money supply, thus lowering the interest rates equilibrium. Which results in an increase in investment, consumption and indirectly, employment and production, ending the situation.

The existence of the liquidity trap was put forward by the economist John Maynard Keynes in his General theory of employment, interest and money. And echoed by John Hicks in the context of IS-LM model, where the interest rate has a minimum rate below which it can no longer plummet.

This is because at such a point investor expectation is that the stock price is high that no one expects them to rise further, as investors would unanimously prefer to keep the money idle.

It is noteworthy that Keynes himself considered this possibility as a theoretical curiosity of little importance and even defended the ineffectiveness of monetary policy. This was more related to the low elasticity of the investment function together with changes in the interest rate than in the specific effects of the liquidity trap.

Over time, he continued defining the liquidity trap as an intellectual curiosity that was not observed in any situation. Its existence has not been accepted by all economists, especially those belonging to the monetarist school considered incompatible with the quantity theory of money.

They believe the liquidity trap model ignores some of the transmission mechanisms that involve the modification of the monetary base. As being too restrictive by considering only the variation of interest rate adjustments caused by leaving out a large set of assets.

By contrast, some economists like Paul Krugman Keynesian postulate that the so-called lost decade of Japan, during 1990, is a very to similar to that described by Keynes, in which nominal interest rates were at near zero. Monetary policy proved unable to revive the economic recession facing the country and end deflation with the established system.

As a result of the liquidity premium of money would apply to investments whose returns are below the iron barrier of about 3%, and no money was to be made available. Such investments would therefore be rendered impractical in physical capital as well as in the credit market.

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