Liquidity trap
Encyclopedia
A liquidity trap is a situation described in Keynesian economics
in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand
, or war
. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.
for money is horizontal). Under the narrow version of Keynesian theory in which this arises, it is specified that monetary policy
affects the economy only through its effect on interest rates. Thus, if an economy enters a liquidity trap, further increases in the money stock will fail to further lower interest rates and, therefore, fail to stimulate.
In the wake of the Keynesian revolution
in the 1930s and 1940s, various neoclassical economists
sought to minimize the concept of a liquidity trap by specifying conditions in which expansive monetary policy would affect the economy even if interest rates failed to decline. Don Patinkin
and Lloyd Metzler
specified the existence of a "Pigou effect
," named after English economist Arthur Cecil Pigou
, in which the stock of real money balances is an element of the aggregate demand
function for goods, so that the money stock would directly affect the "investment saving" curve in an IS/LM
analysis, and monetary policy would thus be able to stimulate the economy even during the existence of a liquidity trap. While many economists had serious doubts about the existence or significance of this Pigou Effect, by the 1960s academic economists gave little credence to the concept of a liquidity trap.
The neoclassical economists asserted that, even in a liquidity trap, expansive monetary policy could still stimulate the economy via the direct effects of increased money stocks on aggregate demand. This was essentially the hope of the Bank of Japan
in the 1990s, when it embarked upon quantitative easing
. Similarly it was the hope of the central banks of the United States and Europe in 2008–2009, with their foray into quantitative easing. These policy initiatives tried to stimulate the economy through methods other than the reduction of short-term interest rates.
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. However, while 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, the liquidity trap invoked in the 1990s referred merely to the presence of zero interest rates (ZIRP), the assertion being that since interest rates could not fall below zero, monetary policy would prove impotent in those conditions, just as it was asserted to be in a proper exposition of a liquidity trap.
While this later conception differed from that asserted by Keynes, both views have in common first the assertion that monetary policy affects the economy only via interest rates, and second the conclusion that monetary policy cannot stimulate an economy in a liquidity trap. Declines in monetary velocity offset injections of short term liquidity.
Much the same furor has emerged in the United States and Europe in 2008–2010, as short-term policy rates for the various central banks have moved close to zero. Paul Krugman
argued repeatedly in 2008-11 that much of the developed world, including the United States, Europe, and Japan, was in a liquidity trap. He noted that tripling of the U.S. monetary base between 2008 and 2011 failed to produce any significant effect on U.S. domestic price indices or dollar-denominated commodity prices.
In October 2010, Nobel laureate Joseph Stiglitz explained how the U.S. Federal Reserve was implementing another monetary policy—creating currency—to combat the liquidity trap. Stiglitz noted that the Federal Reserve intended, by creating $600 billion and inserting this directly into banks, to spur banks to finance more domestic loans and refinance mortgages. However, Stiglitz pointed out that banks were instead spending the money in more profitable areas by investing internationally in commodities and the emerging markets. Banks were also investing in foreign currencies which, Stiglitz and others point out, may lead to currency war
s while China redirects its currency holdings away from the United States.
Economist Scott Sumner has criticized the idea that Japan unsuccessfully attempted expansionary monetary policy during the Lost Decade. Indeed, he claims Japan's monetary policy was far too tight.
economists generally argue that a lack of investment during periods of low interest rates are the result of malinvestment
and time preference
instead of liquidity preference. Most Austrian economists have rejected Keynes' theory of liquidity preference altogether. In his book America's Great Depression
, Murray Rothbard
argued that interest rates are determined by time preference. Says Rothbard, "Increased hoarding can either come from funds formerly consumed, from funds formerly invested, or from a mixture of both that leaves the old consumption-investment proportion unchanged. Unless time preferences change, the last alternative will be the one adopted. Thus, the rate of interest depends solely on time preference, and not at all on "liquidity preference." In fact, if the increased hoards come mainly out of consumption, an increased demand for money will cause interest rates to fall—because time preferences have fallen."
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
, or war
War
War is a state of organized, armed, and often prolonged conflict carried on between states, nations, or other parties typified by extreme aggression, social disruption, and usually high mortality. War should be understood as an actual, intentional and widespread armed conflict between political...
. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.
Conceptual evolution
In its original conception, a liquidity trap refers to the phenomenon when further injections of money into the economy will not serve to further lower interest rates. This can be visualized through a demand curve. Demand for money becomes perfectly elastic (i.e. where the demand curveDemand curve
In economics, the demand curve is the graph depicting the relationship between the price of a certain commodity, and the amount of it that consumers are willing and able to purchase at that given price. It is a graphic representation of a demand schedule...
for money is horizontal). Under the narrow version of Keynesian theory in which this arises, it is specified that monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
affects the economy only through its effect on interest rates. Thus, if an economy enters a liquidity trap, further increases in the money stock will fail to further lower interest rates and, therefore, fail to stimulate.
In the wake of the Keynesian revolution
Keynesian Revolution
The Keynesian Revolution was a fundamental reworking of economic theory concerning the factors determining employment levels in the overall economy. The revolution was set against the then orthodox economic framework: neoclassical economics....
in the 1930s and 1940s, various neoclassical economists
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...
sought to minimize the concept of a liquidity trap by specifying conditions in which expansive monetary policy would affect the economy even if interest rates failed to decline. Don Patinkin
Don Patinkin
Don Patinkin was an Israeli/American monetary economist, and the president of Hebrew University in Jerusalem.- Biography :...
and Lloyd Metzler
Lloyd Metzler
Lloyd Appleton Metzler was an American economist best known for his contributions to international trade theory. He was born at Lost Springs, Kansas in 1913. Although most of his career was spent at the University of Chicago, he was not a member of the Chicago school, but rather a Keynesian...
specified the existence of a "Pigou effect
Pigou effect
The Pigou effect is an economics term that refers to the stimulation of output and employment caused by increasing consumption due to a rise in real balances of wealth, particularly during deflation....
," named after English economist Arthur Cecil Pigou
Arthur Cecil Pigou
Arthur Cecil Pigou was an English economist. As a teacher and builder of the school of economics at the University of Cambridge he trained and influenced many Cambridge economists who went on to fill chairs of economics around the world...
, in which the stock of real money balances is an element of the aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
function for goods, so that the money stock would directly affect the "investment saving" curve in an IS/LM
IS/LM model
The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market...
analysis, and monetary policy would thus be able to stimulate the economy even during the existence of a liquidity trap. While many economists had serious doubts about the existence or significance of this Pigou Effect, by the 1960s academic economists gave little credence to the concept of a liquidity trap.
The neoclassical economists asserted that, even in a liquidity trap, expansive monetary policy could still stimulate the economy via the direct effects of increased money stocks on aggregate demand. This was essentially the hope of the Bank of Japan
Bank of Japan
is the central bank of Japan. The Bank is often called for short. It has its headquarters in Chuo, Tokyo.-History:Like most modern Japanese institutions, the Bank of Japan was founded after the Meiji Restoration...
in the 1990s, when it embarked upon quantitative easing
Quantitative easing
Quantitative easing is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank buys financial assets to inject a pre-determined quantity of money into the economy...
. Similarly it was the hope of the central banks of the United States and Europe in 2008–2009, with their foray into quantitative easing. These policy initiatives tried to stimulate the economy through methods other than the reduction of short-term interest rates.
When the Japanese economy fell into a period of prolonged stagnation
Economic stagnation
Economic stagnation or economic immobilism, often called simply stagnation or immobilism, is a prolonged period of slow economic growth , usually accompanied by high unemployment. Under some definitions, "slow" means significantly slower than potential growth as estimated by experts in macroeconomics...
despite near-zero interest rates, the concept of a liquidity trap returned to prominence. However, while 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, the liquidity trap invoked in the 1990s referred merely to the presence of zero interest rates (ZIRP), the assertion being that since interest rates could not fall below zero, monetary policy would prove impotent in those conditions, just as it was asserted to be in a proper exposition of a liquidity trap.
While this later conception differed from that asserted by Keynes, both views have in common first the assertion that monetary policy affects the economy only via interest rates, and second the conclusion that monetary policy cannot stimulate an economy in a liquidity trap. Declines in monetary velocity offset injections of short term liquidity.
Much the same furor has emerged in the United States and Europe in 2008–2010, as short-term policy rates for the various central banks have moved close to zero. Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
argued repeatedly in 2008-11 that much of the developed world, including the United States, Europe, and Japan, was in a liquidity trap. He noted that tripling of the U.S. monetary base between 2008 and 2011 failed to produce any significant effect on U.S. domestic price indices or dollar-denominated commodity prices.
In October 2010, Nobel laureate Joseph Stiglitz explained how the U.S. Federal Reserve was implementing another monetary policy—creating currency—to combat the liquidity trap. Stiglitz noted that the Federal Reserve intended, by creating $600 billion and inserting this directly into banks, to spur banks to finance more domestic loans and refinance mortgages. However, Stiglitz pointed out that banks were instead spending the money in more profitable areas by investing internationally in commodities and the emerging markets. Banks were also investing in foreign currencies which, Stiglitz and others point out, may lead to currency war
Currency war
Currency war, also known as competitive devaluation, is a condition in international affairs where countries compete against each other to achieve a relatively low exchange rate for their own currency. As the price to buy a particular currency falls, so to does the real price of exports from the...
s while China redirects its currency holdings away from the United States.
Economist Scott Sumner has criticized the idea that Japan unsuccessfully attempted expansionary monetary policy during the Lost Decade. Indeed, he claims Japan's monetary policy was far too tight.
Criticisms
Austrian SchoolAustrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...
economists generally argue that a lack of investment during periods of low interest rates are the result of malinvestment
Malinvestment
Malinvestment is a concept developed by the Austrian School of economic thought, that refers to investments of firms being badly allocated due to what they assert to be an artificially low cost of credit and an unsustainable increase in money supply, often blamed on a central bank.This concept is...
and time preference
Time preference
In economics, time preference pertains to how large a premium a consumer places on enjoyment nearer in time over more remote enjoyment....
instead of liquidity preference. Most Austrian economists have rejected Keynes' theory of liquidity preference altogether. In his book America's Great Depression
America's Great Depression
America's Great Depression is a 1963 treatise on the 1930s Great Depression and its root causes, written by Austrian School economist and author Murray Rothbard. The fifth edition was released in 2000.-Brief summary:...
, Murray Rothbard
Murray Rothbard
Murray Newton Rothbard was an American author and economist of the Austrian School who helped define capitalist libertarianism and popularized a form of free-market anarchism he termed "anarcho-capitalism." Rothbard wrote over twenty books and is considered a centrally important figure in the...
argued that interest rates are determined by time preference. Says Rothbard, "Increased hoarding can either come from funds formerly consumed, from funds formerly invested, or from a mixture of both that leaves the old consumption-investment proportion unchanged. Unless time preferences change, the last alternative will be the one adopted. Thus, the rate of interest depends solely on time preference, and not at all on "liquidity preference." In fact, if the increased hoards come mainly out of consumption, an increased demand for money will cause interest rates to fall—because time preferences have fallen."
See also
- Keynesian endpointKeynesian endpointKeynesian endpoint is a phrase coined by PIMCO's Anthony Crescenzi in an email note to clients in June 2010 to describe the point where governments can no longer stimulate and rescue their economies through increased government spending due to endemic levels of pre-existing government debt."Time,...
- Lost Decade (Japan)Lost Decade (Japan)The is the time after the Japanese asset price bubble's collapse within the Japanese economy, which occurred gradually rather than catastrophically...
- Subprime mortgage crisisSubprime mortgage crisisThe U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
- Zero interest rate policyZero interest rate policyThe zero interest rate policy is a macroeconomic concept describing conditions with a very low interest rate, such as contemporary Japan and, since December 16, 2008, the United States. It can be associated with slow economic growth....
Further reading
- Guti H. Eggertsson, 2008. "liquidity trap" The New Palgrave Dictionary of EconomicsThe New Palgrave Dictionary of EconomicsThe New Palgrave Dictionary of Economics , 2nd Edition, is an eight-volume reference work, edited by Steven N. Durlauf and Lawrence E. Blume. It contains 5.8 million words and spans 7,680 pages with 1,872 articles. Included are 1057 new articles and, from earlier, 80 essays that are designated as...
Online, 2nd Edition. - John Maynard KeynesJohn Maynard KeynesJohn Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...
, 1936. The General Theory of Employment, Interest and Money. Macmillan.