BAJAJ BROKING
November 30, 2024
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A liquidity trap is a highly adverse economic scenario that occurs when people and businesses hold an extremely pessimistic view of an economy. As a result, they refuse to spend and invest much. Typically, when a liquidity trap occurs, interest rates tend to be very low. Hence, the central bank knows that lowering interest rates further will not help. So, the central bank feels powerless.
A liquidity trap is known to happen when people anticipate an adverse event like war or deflation, which makes them postpone their purchases for an extended period of time. As a result, businesses struggle with low demand.
While such a situation can be challenging, central banks worldwide have resorted to quantitative easing and direct transfers of money to the public to overcome a liquidity trap.
A liquidity trap refers to a highly adverse economic scenario that usually occurs when interest rates are extremely low. Low interest rates can result in people neither spending nor investing the cash they have. Instead, they hoard their cash, which can significantly impact economic growth.
When people do not spend or invest, businesses struggle to sell their products or services, which can badly affect economic growth. The term “liquidity trap” was first used by renowned economist John Keynes.
In a liquidity trap, people prefer to keep their cash idle and do not invest it in bonds or other instruments. Hence, Keynes said that a liquidity trap can make monetary policymakers feel powerless because they cannot increase economic growth by reducing interest rates. Having learnt the liquidity trap’s definition, let us delve deeper into this topic.
A liquidity trap typically happens when people are anxious about adverse events, which can be a war or deflation. As they are anxious, they prefer not to spend and hoard cash. In such a situation, interest rates tend to be extremely low and consumer savings tend to be very high.
Consumer savings are high, as consumers refuse to spend much, preferring instead to hoard the cash they have. During normal times, if the central bank thinks that economic growth is low, it can reduce interest rates, thereby providing people with a stimulus to borrow and spend more.
However, in times of a liquidity trap, people are afraid of an adverse event. Hence, they prefer not to spend much. Consequently, even if the central bank lowers the interest rates, it fails to act as a stimulus. As a result, the central bank may feel powerless.
It is called a “trap” because no matter what monetary policymakers do, they find it extremely difficult to stimulate an economy.
A variety of factors lead to a liquidity trap. The most important of them is extremely low interest rates, which can even approach zero. When interest rates are so low, it makes a central bank wonder whether reducing them any further will result in an increase in demand or not.
The other factor that leads to a liquidity trap is deflationary expectations, wherein people start expecting prices to fall. As they expect prices to decline anytime soon, they postpone their purchases, which becomes a vicious circle, resulting in low aggregate demand.
Often, a liquidity trap occurs when businesses and individuals hold a pessimistic view of the economy. As a result, consumption falls and businesses do not invest in expansion. Such a pessimistic view can be caused by reasons like war, etc.
To understand the graphical representation of the liquidity trap, we need to understand the “IS” and “LM” curves in the Keynesian macroeconomic model. The IS curve means the “Investment-Savings Curve.” It shows the relationship between income (Y) and the prevailing interest rate (i) in the goods market. It is a downward-sloping curve. This is because as the interest rate falls, the investment in an economy increases, thereby increasing the income or output. When the interest rate falls, it becomes easier for businesses to borrow and invest, which increases their output/income, and vice versa.
The LM curve stands for the "Liquidity Preference-Money Supply Curve." It demonstrates the relationship between the interest rate (i) and income (Y) in the money market. This is an upward-sloping curve. This is because as income increases, the demand for money increases. When people have more income, they need more money for their transactions. Hence, the interest rate should increase to motivate people to hold the money they have.
Where both these curves (IS and LM) intersect shows the equilibrium in both the money market and the goods market. This point shows the equilibrium income and interest rate in an economy.
As we know, the liquidity trap occurs when the interest rate is really low. Consider the graph below and notice the flat part of the LM curve. At this point, the interest rate will not change if the money supply increases. Hence, any change in the interest rate will not impact income (Y), either.
When an economy is in the grip of the liquidity trap, its investment or consumption does not improve by changing the interest rate.
A liquidity trap can have a severe impact on an economy. It can result in economic stagnation because borrowing and spending decline considerably. As consumers and businesses hold a pessimistic view of the economy, they keep on reducing spending and borrowing.
This results in low economic growth. In worst cases, it can even lead to a decrease in the size of an economy. Because businesses do not grow, unemployment increases, causing people to have less money in their hands, which compounds economic woes.
A liquidity trap also makes a central bank feel powerless because it cannot use its traditional tools (like reducing interest rates) to give a boost to the economy. Hence, a central bank may feel compelled to resort to measures like direct cash transfers to somehow escape the liquidity trap.
Low-interest rates: Interest rates tend to be really low when a liquidity trap occurs. When even low interest rates fail to stimulate the economy, the central bank knows that lowering them further will not help. So, changing interest rates is not much of a choice in a liquidity trap.
High savings rates: As consumers prefer to hoard cash and spend less, they save more, causing savings rates in the economy to increase. Moreover, as consumers keep on postponing their purchases, savings keep on climbing up.
Decrease in investment: In a liquidity trap, businesses fear demand to reduce. Hence, they do not prefer to invest to expand their operations. Consequently, overall investments decline in an economy.
Deflationary pressures: The overall economic outlook becomes grim in a liquidity trap. Businesses are concerned about a decline in demand. Hence, they find it difficult to increase the prices. Moreover, as the overall demand falls, the prices too decline, causing deflation.
Weak consumer confidence: Consumers remain apprehensive of economic uncertainty in a liquidity trap. Hence, consumer confidence tends to be extremely weak, which makes them spend less.
Recessionary risks: As individuals and businesses remain anxious about an adverse event in a liquidity trap, they do not want to spend or invest much. Therefore, individuals and businesses cut their spending, which increases the likelihood of a recession.
Unemployment: When unemployment is caused by businesses avoiding to invest for the fear of an adverse event like war or deflation, then it is an indicator of a liquidity trap.
Unconventional measures: A liquidity trap can cause a central bank to resort to unconventional measures to somehow give a boost to the economy. For example, the central bank may buy a significant amount of government bonds to inject money into the economy or it can resort to direct transfer of money to the public.
While it is difficult to break a liquidity trap, a number of strategies can still be used to overcome it. For example, the central bank can increase interest rates, thereby giving a reason to people to invest their savings and stop hoarding their cash.
The government can increase its spending to compensate for the private sector reducing its spending. When the government spends more on its projects, more people get employment and earn money. Hence, the overall economy may get a boost.
The central bank may resort to quantitative easing, wherein it can buy financial assets from commercial banks. Consequently, the price of those assets may increase, yields may decrease, and the overall liquidity in the economy may increase.
Japan has faced a liquidity trap since the beginning of the 1990s. The Japanese economy witnessed a consistent decline in interest rates and yet investment did not improve. Throughout the 1990s, prices kept on decreasing in Japan. The main stock index of Japan, Nikkei 225, reached a peak of over 38,000 in December 1989. More than three decades since then, Nikkei 225 has not breached that peak yet, which tells us the extent of a liquidity trap in the Japanese economy.
After the subprime crisis of 2008, the US economy faced a severe economic downturn. Consequently, the Federal Reserve reduced interest rates. By December 2008, interest rates were near zero in the US. Even then, the economy did not show signs of recovery and inflation remained low. Even though the Federal Reserve used unconventional measures like quantitative easing, economic growth remained low and unemployment was high in the US in the subsequent years.
If you have a trading account and participate actively in the Indian stock market, it makes sense to learn economic concepts like "liquidity trap." Once you have identified a liquidity trap, it may help you finetune your trading strategies. For example, you may decide to use stop-loss orders more frequently if you think that stock prices may remain low because people are investing less in stocks due to a liquidity trap. Hence, you should improve your understanding of concepts like liquidity trap to become a well-informed trader.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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A liquidity trap occurs when people hoard cash for fear of an adverse event like war or deflation. In such a case, central banks fail to stimulate the economy even by lowering interest rates, which are anyway extremely low. A liquidity trap can result in a recession, low demand, unemployment, or deflation.
A liquidity trap is typically caused by a combination of factors, including a pessimistic view of businesses and consumers about an economy, extremely low interest rates, and expectations of war or deflation.
A liquidity trap makes it extremely difficult for a central bank to boost an economy by lowering interest rates. However, a central bank may increase interest rates, thereby giving an incentive to people to invest rather than hoard cash. It can also make a central bank resort to unconventional measures like quantitative easing.
Yes, the government can choose to spend more on its projects to deal with a liquidity trap. As the government spends more on projects, it can help people in finding employment. When more people have jobs, the overall demand can increase, thereby easing the pressure of a liquidity trap.
From the 1990s onwards, Japan has faced a liquidity trap. Even though interest rates declined in Japan, the economy did not revive and prices kept on falling. The US faced a liquidity trap after the subprime crisis of 2008. Even though interest rates were close to zero in the US by December 2008, its economy did not recover and inflation also remained low.
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