Liquidity Trap

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Liquidity Trap

The inability of a nation’s central bank to decrease the interest rate when it is already very close to zero is known as the “liquidity trap.” It was first referred to by John Maynard Keynes in his 1936 “General Theory.” It was John Hicks, however, who—by laying the foundations of the IS-LM model in the 1930s in an attempt to present and popularize Keynes’s main propositions—put forward the concept of the liquidity trap and its policy implications.

The IS-LM presentation of an economy became a very popular tool for macroeconomic analysis and for policy propositions after World War II (1939–1945). In an IS-LM model, the IS curve is a negatively sloped curve that presents the locus of points in which investment (I) equals savings (S) for all possible combinations of interest rates and levels of output (Y). The LM curve is a positively sloped curve that presents the locus of points in which the demand for money or liquidity preference (L) is equal to money supply (M) for all possible combinations of interest rates and level of income (Y). The intersection point of the two curves represents the equilibrium interest rate and output of an economy. The IS curve represents the real sector of the economy and it shifts outward to the right when aggregate demand increases (and inward to the left when demand decreases). The LM curve represents the monetary sector of the economy and it shifts outward to the right with an expansionary money policy (and inward to the left with a contractionary policy). Hence, economic analysis based on IS-LM analysis suggests that an appropriate mix of fiscal and monetary policies can bring the economy to equilibrium with full employment.

It is argued that the lower left segment of the LM curve is very flat, and that for very low (close to zero) interest rates it becomes horizontal. The reason is that at very low interest rates, economic agents prefer to keep cash for liquidity purposes. Financial assets are not as desirable in this situation because their liquidity is lower and their yield is close to zero. Hence, the liquidity preference schedule becomes infinitely elastic due to investors’ expectation that the rate of interest cannot fall any further, and because bond prices are so high that no one expects them to rise still higher. In this flat state, the economy is in “liquidity trap,” meaning that interest rates are so low that people are indifferent between holding money or other assets. The demand for money is therefore infinitely elastic.

The liquidity trap hypothesis has led to a theoretical dispute over the extent to which the demand for money depends on interest rates. Neoclassical and monetarist economists argue that the interest rate is determined in the real sector, and that money, by being neutral, makes monetary policy an ineffective tool. Keynesians, on the other hand, argue that interest rates are defined in the money market, and that money is not neutral. In fact, the liquidity trap hypothesis rests on the neutrality of money, whereas Keynes’s analysis of conditions of less than full employment is predicated on the nonneutrality of money. Another implication of a liquidity-trap situation is that neoclassical analysis becomes inconsistent at such low interest rates, since the system can be in equilibrium at less than full employment. In fact, the liquidity trap argument suggests that the neoclassical case has no equilibrium solution; that is, it does not include a positive interest rate that will equate investment and demand.

According to neoclassical analysis, interest rates are the equilibrators of both capital and goods markets. Interest rates keep investment equal to saving at full employment levels, and as a result the real full equilibrium of the economy is independent of nominal prices. The neoclassical proposition, often associated with the quantity theory of money, states that the interest elasticity of money demand is zero, and that with perfect flexibility of all wages and prices (present and future), full employment will be maintained. On the other hand, Keynes’s suggestion is that a perfectly competitive economy does not, in fact, tend automatically toward full employment. The inflexibility of wages and prices, the low interest-elasticity of investment demand, and the liquidity trap might all suffice to prevent attainment of full employment equilibrium.

According to Keynesians, if the economy is stuck in a liquidity trap, a shift of the IS curve to the left (lower aggregate demand) does not allow for the intersection of aggregate demand and supply curves, suggesting that wages and prices will fall continuously and there will be no equilibrium. In other words, the problem with the neoclassical analysis is that equilibrium output, either on the supply side or on the demand side, does not respond to the price drop in the liquidity-trap case. In fact, as Keynes argued, it is possible for interest rates to fall so low in the neoclassical model that neither an expansionary monetary policy nor falling prices could ever increase the level of demand-side equilibrium output. Thus, with employment determined in the labor market and demand caught in the liquidity trap, the neoclassical model offers no solution.

The British economist Arthur Pigou attempted to remove this inconsistency in the neoclassical model by suggesting that falling prices would increase consumers’ real wealth, leading to increased spending and reduced saving (the “real balance effect”). The rise in real consumption that occurs with falling prices would shift the IS curve out and raise the level of demand-side equilibrium output. This solution to the inconsistency in the neoclassical model generally implies that, after a long period of falling wages and prices, equilibrium will be reestablished. However, in the 1930s, the U.S. economy seemed to reach a different result: a fairly stable low level of employment with wages and prices dropping to a fixed level. Another solution to inconsistencies arising from the neoclassical analysis in liquidity trap conditions is the rigidwage hypothesis, which allows for the equilibrium intersection between demand and supply.

Keynes mentioned that he was not aware of there ever having been a liquidity trap. Yet in 1998, Japan’s interest rate was almost zero and output had barely changed, even in the face of expansionary monetary policy by the Bank of Japan, the nation’s central bank. Thus, the Japanese government pursued an expansionary fiscal policy in its effort to increase output. The liquidity trap analysis should therefore clearly be part of the argument, which reveals that Keynesian economics teaches us that the automatic adjustment mechanism of competition cannot be relied upon for purposes of achieving certain policy objectives, such as full employment and price stability.

SEE ALSO Economics, Keynesian; Interest Rates; Keynes, John Maynard; Liquidity; Money; Money, Demand for; Policy, Monetary; Unemployment