Liquidity Trap

A liquidity trap is a situation in which monetary policy loses its grip because interest rates are already so low that people are content to hold any extra money rather than lend, invest or spend it. A central bank can expand the money supply, but the new money sits idle in bank accounts and reserves, rates do not fall further and demand does not recover. The concept comes from John Maynard Keynes's analysis of the demand for money in the 1930s.

In modern usage the term usually describes an economy stuck at the zero lower bound on interest rates while output is below potential and inflation is weak. It is a central idea in Keynesian economics and is often discussed together with deflation, quantitative easing and the case for fiscal policy.

Picture a garden hose feeding a pond that has a hidden drain. Normally, turning up the tap raises the water level. In a liquidity trap the extra water simply runs into the drain: the central bank opens the tap, but the level that matters, spending in the economy, barely moves.

The drain is people's willingness to sit on cash. When interest rates are near zero, keeping money idle costs almost nothing, and if people expect prices to fall or the future looks uncertain, holding cash feels safer than buying, building or lending. So more money does not turn into more activity.

In The General Theory of Employment, Interest and Money (1936), Keynes argued that interest rates are set by the demand for money, which he split into three motives in his liquidity preference theory. The speculative motive is the key to the trap. When rates are very low, almost everyone expects them to rise, and a rise in rates would cut the price of bonds. Holding money avoids that loss.

The arithmetic can be seen with a perpetual bond that pays a fixed coupon forever:

• $P$ is the bond's price.
• $C$ is the fixed annual coupon.
• $i$ is the market interest rate, as a decimal.

With a coupon of £1 and a rate of 1%, the price is $1 \div 0.01 = 100$, or £100. If the rate rises to 2%, the price falls to $1 \div 0.02 = 50$, or £50. The holder earns £1 of interest but risks a £50 loss, so at very low rates people prefer cash, and the demand for money becomes almost unlimited. Keynes treated this as a theoretical possibility and said he knew of no example. John Hicks's 1937 IS–LM model, a staple of macroeconomics teaching, drew the trap as a flat section of the money-market curve.

The idea returned in 1998, when Paul Krugman argued that Japan, with interest rates near zero and falling prices, was in a liquidity trap. In his version the problem is that the economy needs a negative real interest rate, which a zero nominal rate cannot deliver when expected inflation is low. After the 2008 Financial Crisis, the United States, the United Kingdom and the euro area faced similar conditions, and the large reserves created by central banks were largely held by banks rather than lent out (see interest on reserves).

Typical features include:

• Policy rates at or near zero, as under zero interest-rate policy.
• Weak demand, an output gap and inflation below target.
• High saving and cash hoarding by households, firms and banks, often alongside debt reduction after a credit crunch.
• A falling velocity of money, since new money is spent less often.

• Raising inflation expectations. Krugman argued that a central bank should credibly promise to tolerate higher future inflation, lowering real rates. Forward guidance and average inflation targets follow this logic.
• Unconventional monetary policy. Asset purchases, yield curve control and negative interest rates aim to lower long-term and real rates.
• Fiscal expansion. Keynesians argue government spending is especially effective in a trap, because higher borrowing does not push up rates and so causes little crowding out.
• Monetary financing. Some economists propose money-financed spending, sometimes called helicopter money, a form of monetary financing; critics warn of inflation and lost central bank credibility.

Monetarists such as Milton Friedman doubted that liquidity traps occur in practice, arguing that a central bank can always raise spending by buying enough assets, including long-term bonds, foreign currency or other assets. Economists in the Pigou tradition argued that falling prices raise the real value of money holdings and so revive spending through a wealth effect. Others question whether post-2008 economies were truly trapped, noting that QE did lower long-term yields. Defenders reply that the slow recoveries and persistent low inflation of the 2010s fit the liquidity-trap account.

• Brookings Institution: Paul Krugman, "It's Baaack: Japan's Slump and the Return of the Liquidity Trap" (1998)