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A liquidity trap is a situation, described in Keynesian economics, 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 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,
Negative natural interest rates and a zero lower bound are necessary conditions of a liquidity trap. Temporary economic disruption (e.g. banking crises, excessive debt accumulation) and structural factors (e.g. demographic decline, inequality) can produce negative natural interest rates. Credible monetary policy can overcome liquidity traps.
A liquidity trap is caused when people hold 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 lower bound and changes in the money supply that fail to translate into changes in inflation.Krugman, Paul R. (1998) "It's baack: Japan's Slump and the Return of the Liquidity Trap," Brookings Papers on Economic Activity
The Great Depression, the Great Recession and Japan's Lost Decades are examples of liquidity traps.
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's potential impotence was further worked out in the works of British economist John Hicks,John Hicks (1937) " Mr Keynes and the Classics: A Suggested Interpretation", Econometrica, 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–money supply" (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, 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 monetary base and bonds are viewed by the private sector 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.
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 Capitalismwebsite, 23 July 2014
Post-Keynesian economist Hyman Minsky positedHyman Minsky (1986 2008) 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 money supply with a fixed head count of other [financial assets]] 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,Hyman Minsky (1975 2008) 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 with respect to variations in the interest rate… The liquidity trap presumably dominates in the immediate aftermath of a recession or financial crisis.
, most notably Milton Friedman, 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.Antonopoulou, Sophia N. (2009) " The Global Financial Crisis", The International Journal of Inclusive Democracy, Vol. 5, No. 4 / Vol. 6, No. 1, Autumn 2009/Winter 2010 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, 5 September 2016 Some economists, such as Nicholas Crafts, have suggested a policy of inflation-targeting (by a central bank 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 economists, such as those of the Ludwig von Mises Institute, 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 rather than liquidity preference." The Liquidity-Trap Myth" by Richard C.B. Johnsson, The Mises Institute, 13 May 2003 Chicago school economists remain critical of the notion of liquidity traps.
Keynesian economists, like Brad DeLong and Simon Wren-Lewis, maintain that the economy continues to operate within the IS-LM model, albeit an "updated" one, and the rules have "simply changed."
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.
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 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.Wray, L. Randall (2013) " Reconciling the Liquidity Trap With MMT: Can DeLong and Krugman Do the Full Monty With Deficit Owls? ", Economonitor, 1 May 2013
Taking the precedent of the 2008 financial crisis, criticsRoche, Cullen (2014) " Would Keynes Have Called this a “Liquidity Trap”?", Pragmatic Capitalism website, 23 March 2014 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. See TED rate for the period 2007/16 the critics of the mainstream definition claimPilkington, 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; Treasuries may in some cases be treated as cash equivalents and not "debt" for liquidity purposes.
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