The liquidity trap is the macroeconomic situation in Keynesian theory , when monetary authorities have no tools to stimulate the economy either through lowering interest rates or by increasing money supply . Keynesians argue that a liquidity trap usually occurs when expectations of negative events ( deflation , weak aggregate demand , civil or world war) force people to increase their preference for liquidity .
Definition
In this macroeconomic situation, real interest rates cannot be reduced even lower by any actions of the monetary authorities due to expectations of a fall in prices. If it is expected that the overall price level will fall, everyone prefers to keep cash, as this leads to an increase in real gain equal to the level of deflation. The real interest rate cannot be reduced below the level at which the nominal interest rate is zero, regardless of the increase in money supply. Thus, monetary authorities are unable to stimulate investment by lowering real interest rates.
Concept Development
The initial concept of a liquidity trap referred to a situation where additional injection of money into the economy did not lead to lower interest rates. This situation can be illustrated using the money demand curve. Demand for money becomes completely elastic (that is, it will be a horizontal line). According to the narrow version of Keynesian theory, when monetary authorities influence the economy only through interest rates, in a situation of liquidity trap, an increase in the money supply is not able to further reduce rates, and therefore is not able to stimulate the economy.
During the Keynesian revolution of 1930β40, various neoclassical economists tried to find weaknesses in the concept of a liquidity trap by determining the conditions under which an expansive monetary policy would lead to economic growth, even if interest rates could not be reduced. Don Patinkin and Lloyd Metzler discovered the existence of the β Pigou effect β, named after the English economist Arthur Cecil Pigou , according to which real money supply is an element of the function of aggregate demand for goods, so that money supply has a direct effect on the IS curve ( investment - savings ) in IS-LM models . Thus, monetary policy is able to stimulate economic growth even in the presence of a liquidity trap.
Neoclassical economists argue that even in a liquidity trap, expansive monetary policy can stimulate the economy through the direct effect of increased money supply on aggregate demand. This was the main hope of the Bank of Japan in the 1990s when it undertook quantitative easing . Similarly, this became a hope for the central banks of the USA and Europe when they began to conduct quantitative easing in 2008-2014.
From a monetarist point of view, quantitative easing was primarily aimed at keeping money supply at the pre-crisis level, since an increase in risks during the crisis led to a decrease in the money multiplier and the money supply corresponding to the pre-crisis level of GDP . Otherwise, a decrease in the money supply could cause a recession and a decrease in GDP. But the task of stimulating economic growth by increasing money supply was not even set.
See also
- Keynes, John Maynard
- Keynesianism