LIQUIDITY TRAP

Liquidity Trap

Liquidity Trap

Introduction

The essential idea of a Liquidity Trap as expounded by J M Keynes in this “General Theory” is that there is a point in time, when the interest rate has fallen so low, that investment bonds, be they public or private, are returning so little, that the investor then decides to keep all his money as a cash balance. This then snuffs out any further economic activity that may have been brought about by the former investments. There is a general freezing up in the economy and a Recession becomes a Depression.

It is fashionable in all sectors of the media, politicians and economists to say that they  think this event is happening right in front of our very own eyes. In the famous circular flow of income that the Keynesians adhere to, one man's spending is a another man's income. Is it possible that a person would not spend anything in a Liquidity Trap? I think not. All people have to buy their day to day food stuffs, pay for heating, pay for shelter and other such basics.

Having excess cash balance simply means that you are choosing to keep your money as cash for later use.  You produced goods and services in exchange for money (cash) which you have kept as money, ready to exchange for other goods and services at a moment of you're choosing.

Liquidity Trap

When cuts in policy interest rates seem to have little or no impact on aggregate demand, then the economy can experience a liquidity trap. When interest rates are close to zero as they are in the UK, the USA and in the Euro Zone, people may expect little or no real rate of return on their financial investments, they may choose instead simply to hoard cash rather than investing it. This causes a fall in the velocity of circulation of money and means that an expansionary monetary policy appears to become impotent. If monetary policy is ineffective in stimulating demand, the solution may be to use fiscal policy or unconventional measures such as quantitative easing as a means of kick-starting demand and output in an economy mired in a slump. (Clark 2009 45-47)

In popular accounts of Japan's problems one often hears a litany of supposed causes. Some argue that the problem is structural, rooted in both demography (ageing and a declining working-age population) and in waning technological vigor. Others suggest that specific events - in particular, the severity of the collapse of the bubble economy - have jolted Japan into a self-reinforcing spiral of pessimism. Finally, one sometimes hears that the bubble left problems of a more tangible nature, namely large debts that burden enterprises and leave them unable to take advantage even of promising investment opportunities.

The purpose of this paper is to discuss the general problem of the liquidity trap, rather than get too much into Japanese specifics, so I can remain agnostic about these differing claims (although as a practical matter I would argue that the cases for both self-fulfilling pessimism and ...