What is Liquidity Trap?
In economics, liquidity means a state of having more cash. While liquidity trap means a situation where too much cash circulating in the economy becomes a problem. Here, cash does not mean physical cash. It refers to the aggregate money supply within the economy. In other words, a liquidity trap is a situation where the expansionary monetary policy is ineffective in increasing the interest rate or stimulating economic growth.
Scripbox Recommended Goals
Plans that will help you to achieve your life goals across multiple time frames.
Typically, the liquidity trap occurs when the interest rates in the economy are extremely low. Also, people prefer to hold their money in cash, i.e. a savings account, as they are uncertain about the performance of the nation’s economy. Thus, this situation makes monetary policy ineffective.
The nation’s central bank, like the Reserve Bank of India or the Federal Bank in the USA, tries to stimulate the economy by increasing the money supply. This is done to discourage investors from holding additional cash. However, consumers continue to maintain their funds in deposit accounts instead of investment accounts even though the central bank injects additional funds. Therefore, the higher the cash holding levels, the more the probability of an adverse economic condition.
For instance, consumers hold cash and sell bonds. Eventually, this will impact the bond prices, and yields will rise. With increasing yields, consumers are not willing to buy bonds as prices are falling. They prefer holding cash over a lower return. In such a scenario, the interest rates are already close to zero. Hence, if there is any recession, the central bank will not be able to do anything to control the situation.
How to Identify Liquidity Traps?
Following are the four indicators to identify liquidity traps –
1. Low-Interest Rate
This primary indicator of a liquidity trap is low-interest rates in a country for a prolonged period. Also, this can change bondholders’ behaviour when they start selling bonds which is harmful to the economy. Even though the government makes additions to increase the money supply, consumers prefer holding funds in a savings account as a low-risk option.
2. Recession Trend
Typically, this situation arises when the economy is recovering from a recession. In such cases, the government tries to boost economic growth through expansionary policies with the aim of increasing spending and investment. There is a contrary effect, where the savings level rises in the market if the interest rates are too low (almost close to zero) for a long time.
The effect of the recession leads to a surging level of unemployment in the country. This implies reduced income in the hands of consumers. Thus, with lower income, consumers tend to save surplus funds to meet any emergency expenses in future rather than investing or spending them. As a result, a reduction in interest rates will not affect the economic revival.
The price level in the economy falls due to depressed consumer demand. This trend will have a negative impact on the economic growth rate of the country. Also, it discourages the manufacturers from producing more due to low profits. As a result, this has an adverse impact on the country’s GDP.
Causes of a Liquidity Trap
A liquidity trap is caused when people hold surplus cash, which can have an adverse effect on the economy, like deflation, insufficient aggregate demand or war. In other words, this situation is generally seen after a recessionary period. People prefer to hold cash in a savings account rather than invest or spend. Therefore, even though there is a money supply in the market, a situation of low-interest rates fails to attract consumers.
The year 2008 global recession is a classic example of a liquidity trap. The US economy failed, and the central banks adapted to almost zero interest rates. It tried to enhance liquidity in the market since people were holding on to cash for fear of global depression.
Even though the monetary base was tripled, the low lending interest rates did not produce significant results on the domestic price indices or the economy. Thus, it led to a liquidity trap.
Advantages of Liquidity Trap
Following are the advantages of a liquidity trap –
- A market of cheap borrowing options is created where people or companies can avail of affordable loans for borrowing.
- It forces the central government to audit existing monetary policies and develop new policies and ideas to match the current economic conditions.
- This situation can inculcate a habit of savings among consumers.
Disadvantages of Liquidity Trap
Following are the disadvantages of a liquidity trap –
- The liquidity trap generally occurs after a recessionary period. Sometimes, this can unintentionally further enhance the problem rather than solving it.
- This phase makes the central bank lose one of its prime powers to improve the economy with interest rate factors and stimulate growth.
- The risk of coming out of the liquidity trap can be inflation because excess money is available in the economy.
- There is a rise in unemployment because companies adapt to lay off cost resources and hire other resources at a lower cost. Also, it declines the wages and people are forced to compromise with goods and services.
- When interest rates are close to zero, there is a lack of deposits in banks, and the income from loans is not encouraging. Hence, banks become reluctant to provide loans.
- Insurance companies are largely affected due to low-interest rates. These companies rely on interest-based returns on the sum they receive from customers as premiums to cover liabilities. Hence, this may lead to a rise in insurance premiums.
How to Deal With Liquidity Trap?
There are several ways to help the economy deal with the liquidity trap. The following are ways to overcome the liquidity trap by stimulating demand.
1. Increasing Interest Rates
The interest rate the central bank offers plays a key role. Increasing the short-term rates stimulates people to invest instead of hoarding it. Also, a rise in long-term rates encourages banks to lend as they will get higher returns. As a result, it enhances the flow of money within the economy.
2. Fall in Price of Goods & Services
The economy can start improving if the price of goods and services falls so low that people cannot resist spending. This applies to both consumer goods and assets like stocks. Investors start buying again because they can hold onto the asset for long to outlast this phase.
3. Expansionary Fiscal Policy
The liquidity trap can end through the expansionary fiscal policy by the government. The central government can take steps to reduce taxation or increase government spending. This creates confidence among the public that the government will support economic growth. Also, it helps create jobs and reduces unemployment and the hoarding of cash.
4. Financial Restructuring
Financial restructuring and innovation can help to set up a new market and overcome the existing trap. This makes financial assets like stocks, bonds or derivatives more attractive than holding cash.
5. Global Co-operation
If some countries are experiencing a liquidity trap and others are not, the government can end the trap through global cooperation. This is where two or more nations with excess or deficit cash can come together and help each other’s problems for a mutual balance.
To conclude, a liquidity trap can have a devastating impact on the economy if not solved immediately. Usually, expansionary fiscal policies work in most cases. A highly developed economy often faces challenges in reviving the aggregate demand level. At the same time, individuals tend to hoard wealth till economic stability. Experienced investors take advantage of this situation by making value stock purchases (or mutual funds) as they trade at a lower price. Also, investors can enjoy higher rewards when the economy recovers because the prices may increase in an economic boom.
Implications of Liquidity Trap
A liquidity trap has implications on the bond and stock markets.
- Impact of liquidity trap on the stock market: The uncertainty around a company’s performance during a liquidity trap has a significant impact on the equity market. Investors are not confident about the success of the company in the near future. As a result, these companies’ cash flows are reduced, which negatively affects their production levels and, ultimately, the GDP of the country.
- Impact of liquidity trap on the bond market: Bond market investments decline dramatically as well because of the inverse relationship between bond prices and interest rates. Any increase in market interest rates prompts investors to choose alternate schemes, such as fixed deposits. Since bonds are traditionally linked with a fixed interest regime. As a result, there is less demand for bonds, which causes their price to decline.
People anticipate rising interest rates from their current insignificant levels in the event of liquidity traps, which will cause bond prices to decline. Therefore, rather than investing their money, people prefer to keep it in cash or a regular savings account because of fear of capital losses.
Therefore, expansionary monetary policy has little effect on increasing investment levels. Individuals would rather hold onto their money than invest in anticipation of low returns and/or uncertain markets.
- Other Impacts: A continuous slowdown may impact macroeconomic stability. Furthermore, liquidity traps may also cut institutional interference.
Frequently Asked Questions
One of the risks of coming out of a liquidity trap is inflation. Due to the excess money available in the economy, there is a high chance of inflation.
People may hold cash during a liquidity trap for many reasons. It may be due to a lack of confidence in the markets to earn higher returns, anticipating a deflation, or believing that the economy is in deflation already. Furthermore, people may also believe that interest rates may rise soon and thus wish to deploy them in traditional investment avenues like FDs and savings accounts.
Explore: Fund Flow Statement