Liquidity trap

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A liquidity trap is a situation in monetary economics in which a country's nominal interest rate has been lowered nearly or equal to zero to avoid a recession, but the liquidity in the market created by these low interest rates does not stimulate the economy. In these situations, borrowers prefer to keep assets in short-term cash bank accounts rather than making long-term investments. This makes a recession even more severe, and can contribute to deflation.[1]

In normal times, the monetary authority (usually a central bank or finance ministry) can stimulate the economy by lowering interest rate targets or increasing the monetary base. These actions are meant to increase borrowing and lending, consumption, and fixed investment. When the relevant interest rate is already at or near zero, lowering it to a level which would stimulate the economy may not be possible. The monetary authority can increase the overall quantity of money available to the economy, but traditional monetary policy tools do not inject new money directly into the economy. Rather, the new liquidity created must be injected into the real economy by way of financial intermediaries such as banks. In a liquidity trap, banks are unwilling to lend, so the central bank's newly-created liquidity is trapped behind unwilling lenders.

The liquidity trap theory applies to monetary policy in non-inflationary depressions. The theory does not apply to fiscal policies that may be able to stimulate the economy.[citation needed]


[edit] Economists' perspectives

Milton Friedman suggested that a monetary authority can escape a liquidity trap by bypassing financial intermediaries to give money directly to consumers or businesses. This is referred to as a money gift or as helicopter money. The term helicopter money is meant to portray the image of a central banker dropping money on people from a helicopter. Political considerations make it difficult for a monetary authority to grant the money gift, because individuals and firms not receiving free money will exert political pressure. The monetary authority must act covertly to give gift money to specific individuals or firms without appearing to give money away. During the Great Depression in the United States, the Federal Reserve offered to buy any gold at a price well above current market prices. This was essentially a money gift to gold holders.[citation needed]

John Maynard Keynes is usually seen as the inventor of the liquidity-trap theory. In his view, financial actors fear the possibility of suffering capital losses on non-money assets and thus hold money (liquid assets) instead. For example, the fear of default on loans can inhibit lenders from lending except to extremely credit-worthy customers. These fears are most likely after a financial crisis such as that associated with the Stock Market Crash of 1929.[citation needed]

Neoclassical schools of economics which hold that economic agents make decisions based on real rather than nominal values contend that monetary efforts to lower nominal risk-free rates have no significant impact on the nominal interest rates charged by banks. A bank will not lend unless it can charge a (nominal) interest rate which is at least equal to the rate of inflation during the loan period. In an environment where banks are prohibited or discouraged by law from charging high rates of interest on loans, banks will be more reluctant to lend, since doing so would result in receiving a low (and possibly negative) real rate of return on investment. Unlike Keynesian theory, which claims that "liquidity traps" arise from fear or a hoarding mentality among banks, neoclassical theories argue that liquidity traps of this form do not exist and that monetary efforts to lower rates will have little, if any, effect on the quantity of real goods produced.

Note that even if the expected inflation rate is zero, nominal interest rates charged for loans will never fall below zero. Negative interest rates would imply banks paying borrowers to take loans. Furthermore, the liquidity advantages of holding money in an uncertain environment will set a non-zero, positive lower bound on the rate at which any agent will be willing to lend.[citation needed]

[edit] Japan's liquidity trap

It has been suggested that the Japanese economy in the 1990s suffered from a "liquidity trap" scenario.[2] This diagnosis prompted increased government spending and large budget deficits as a remedy. The failure of these measures to help the economy recover, combined with an explosion in the Japanese public debt, suggest that such a fiscal policy may not have been adequate.

Some economists believe that much of Japan's government spending followed a stop/go pattern and involved spending on unneeded infrastructure. American economist Paul Krugman suggests that what was needed was a central bank commitment to steady positive monetary growth, which would encourage inflationary expectations and lower expected real interest rates, which in turn would stimulate spending.[3]

[edit] Austrian Critique

Economists of the Austrian school challenge the idea that Japan experienced a liquidity trap, contending instead that it suffered from the bust portion of a business cycle brought on by monetary inflation, which could only be cured by allowing the bust to liquidate the malinvestments made during the boom. Austrians contend that busts are necessary corrections to booms and that artificial credit expansion or other government interference will only make the bust longer or delay an even bigger bust. Thus, they blame Japan's rigorous government interference in the market for causing the bust to last throughout the decade. [4]

However, this critique is generally considered to be inadequate insofar as it does not really contradict the Keynesian liquidity trap thesis. Keynes also accepted that overinvestment and malinvestment drove the business cycle, which is essentially the Austrian point. What Keynes contributed was the idea that given a sufficiently severe bubble-burst at the outset of a recession, firm uncertainty about losses on non-money assets could lead them to hoard cash, underinvest, and prolong the recession. The Austrian "critique" confirms what Keynesian theory already accepts as the cause of recessions, but does nothing to address the Keynesian argument about how recessions are prolonged.[citation needed]

Austrians would counter that business cycle theory is separate from the effects of other government policies that are often implemented to "cure" the bust, which they blame for inadvertently prolonging it. Such measures include subsidizing failing businesses or unemployment, relieving bank obligations, propping up prices (including wages), increasing taxation/debt and public spending (such as stimulus programs), greater inflation of the money supply (quantitative easing, re-flation, lower interest rates), discouraging saving, and raising tariffs. During past busts, such as 1921, when government avoided such policies, the period of stagnation generally passed quickly. [5]

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