Concept of liquidity trap
The liquidity trap is an explanation given by John M. Keynes for a monetary-financial event that occurs when the interest rate is very low.
Keynes estimated that this phenomenon would occur when the interest rate was equal to or less than 2% per year.
Description of liquidity trap
This phenomenon can be described as follows: since the interest rate is very low, an increase in the money supply will not lead to the purchase of securities because investors imagine that the prices of these stocks are very high and thus tend to fall, in the same way, that the interest rate tends to increase. In this way, the increase in the money supply only induces the hoarding of money. Thus, the interest rate does not change.
The term ‘liquidity trap’ applies to an economy where monetary policy has lost its effectiveness because investors prefer to maintain liquidity either because they expect deflation or very low inflation or because they consider aggregate demand to be insufficient. That is, economic agents prefer to save their money to lend it or invest it because they consider the unfavourable situation.
As a result, we see low levels of credit to non-financial corporations and households, despite an expansionary monetary policy. Banks are cheaper to finance but require tight credit margins. This process aggravates the economic situation and therefore becomes a vicious circle. Hence a “trap” is called.
In this context, monetary policy loses effectiveness because the available liquidity will simply be stored by the banks. Thus, the only solution is to activate the fiscal policy, putting the state as a starter for the economy, mobilizing private savings.
Consequences of this phenomenon
The main consequence of the liquidity trap is the possibility that the economy can enter a deflationary spiral.
Deflation refers to the general decline in prices of goods and services over a long period of time, ie there is a prolonged reduction in the consumer price index.
What happens is that, in the event of an unfavourable shock to the economy to provoke recession and deflation, the rigidity of the nominal interest rate will imply a rise in the real interest rate, with additional recessionary and deflationary effects in the economy. These effects will be exacerbated if there is a rigidity of nominal wages, in which case deflation will also cause real wages to rise, further contributing to deep the recession.
In the Euro Zone, successive reductions in benchmark interest rates in the last two years, as well as unconventional liquidity measures, were not reflected in the desired increase in credit levels to the real economy. Assuming that the eurozone may be in a liquidity trap, the decision to reduce interest rates is only relevant if it is linked to strongly expansionary fiscal policies.
Advances in the study of the liquidity trap
The traditional theory of the liquidity trap belongs to neoclassical economists, of which Keynes was a worthy representative. The need to construct a model to analyze the Lost Decade of Japan (a designation given to the economic stagnation experienced by Japan since 1990) has made the study of the concept of a liquidity trap regain importance and culminate in its reshaping.
Whereas in the traditional version this phenomenon emerged from a context of uncertainty, in the modern version it results from a negative shock to a system of equations in equilibrium. Generally, this shock occurs on the dynamic aggregate demand equation derived from the optimizing behaviour of the economic agent.
