What Does Liquidity Trap Stand For?

The economy is a complex system of interrelated elements, an essential part of which is the capital market and investment activity. A benign economic situation maintains a stable level of investment activity, but during periods of difficult financial situations and shocks, the phenomenon of liquidity trap appears due to the peculiarities of the central bank’s national monetary policy.

This article will shed light on the question of what liquidity trapping is, what its main characteristics are, and methods of prevention.

Liquidity trap  a situation in the economy in which, in response to shocks, traditional monetary policy cannot return actual output to the level corresponding to the potential. This situation occurs when a central bank cannot incite aggregate demand by reducing interest rates or opening market operations because nominal interest rates in the economy have already reached zero levels. Thus, the idea of the economy falling into a liquidity trap is that, at a near-zero, critically low-interest rate level, the population has an absolute (or near-absolute) preference for liquidity. This is expressed in the population’s preference to keep cash at almost any level of money supply rather than to invest in securities because the investment cost, the interest on securities, turns out to be unprofitable.

Economic agents are driven by the expectation of rising interest rates, which gives them a reason to fear the depreciation of present investments in the future and, thus, to preserve funds for potentially more profitable investments. In such a case, the increase in money supply, which the Central Bank can carry out through market operations, will not lead to the desired effect of “boosting” the economy through increased investment and consumer activity; excessive cash will be retained by the population rather than spent or invested. And the direct impact on the economy by lowering the interest rate becomes limited due to its already low values. Thus, the question arises about the efficiency of the instruments of monetary regulation of the economy, as well as about additional possible and more preferable methods of influence on the stimulation of output in such a situation.

Based on the above, the liquidity trap is a situation arising from the peculiarities of the conduct of fiscal policy by the central bank during periods of difficult economic situations, especially recession. This phenomenon has a number of distinguishing characteristics, which are given below. 

In the period of economic turmoil, there is a situation in which there is a sharp decline in investment activity and the outflow of large amounts of capital from financial markets, as well as cash-out of funds from bank deposits and lack of credit activity even with low-interest rates, which as a consequence leads to the active use of cash.  This occurs against the background of instability arising in the financial markets and, as a consequence, the fear of investors to invest money in trading instruments for profit in the short term.

The interest rate is one of the instruments of regulation within the framework of the central bank’s monetary policy: measures to reduce it are aimed at boosting investment processes and consumption. In contrast, its increase is aimed at preventing excessive business activity and reducing the inflation rate.

Under adverse economic circumstances in the event of a liquidity trap, the government tries to reduce to the minimum possible level of interest rates to incite economic activity, especially in financial markets, but these measures do not bring results because, in this case, the storage of money in the markets becomes unprofitable, and cash has more liquidity.

In the context of the liquidity trap, the level of investment activity is formed under the influence of the current and expected dynamics of the macroeconomic environment and the free market, as well as the state’s fiscal policy. Hence, the state measures to incite economic activity as part of unfavorable economic developments. In this situation, the law of stimulating consumer activity and, consequently, economic growth by increasing money supply and decreasing interest rates does not work. Monetary policy has limitations related to the impossibility of lowering rates below zero, which raises the question of other ways to stimulate consumption and investment.

The presence of the liquidity trap causes such phenomena as deflation in which there is a steady decline in the general price level of products and services accompanied by a low level of inflation, when the value of cash increases in direct proportion to the decline in investment activity, which in turn can lead to economic recession in the worst scenario. 

When a liquidity trap occurs, the likelihood of an economic recession increases many times, implying a significant decline in economic growth that lasts for months or even years. In this case, the gross domestic product (GDP), the level of industrial production, real income and expenditures of the population, as well as the unemployment rate decrease.

The liquidity trap is a very specific, albeit rare, phenomenon, the fight against which is not limited to proven economic solutions due to their low effectiveness. However, there are more effective methods of solving the difficult economic situation, aimed mainly at stimulating investment activity instead of savings. None of these methods work in full force separately from the others, so a combination of them is often used.

In a difficult economic situation, the federal system may take steps to raise interest rates to encourage the public to invest money instead of keeping cash. These measures involve an increase in the key interest rate, which, as a result, leads to an increase in interest rates on bank deposits, as well as on coupon payments as part of investing in bonds on the stock market. However, such a move can be risky during a recession and low inflation.

Decreasing the level of consumer prices is a good tool for increasing the liquidity of both cash and non-cash forms. This achieves an increase in the demand for goods, which also helps to achieve another goal – to encourage people to save money and stimulate buying activity. In addition to the positive effects described above, lower prices can stimulate production growth.

In order to stimulate economic activity, the government can actively allocate additional funds within the framework of regulatory measures aimed at stimulating spending and artificially lowering interest rates to below 0 level through the purchase of various securities such as bonds with extended maturities.

A negative interest rate is an interest rate with a negative value, i.e., below zero percent, when used by a central bank, as a form of monetary policy, especially during a liquidity trap.

A negative interest rate on deposits means that companies or people who keep money in an account with a negative interest rate will pay the bank to hold their money. A negative interest rate on loans implies that the bank will have to make the loan and pay its borrowers extra on the loans.

Despite its rarity, the liquidity trap phenomenon is a dangerous situation for the stability of economic processes, which can create negative consequences in the form of reduced investment activity, deflation and, in particularly severe cases, economic recession, the fight against which requires the use of radical measures.