Saturday, October 21, 2017

Liquidity Trap Explained

A liquidity trap occurs when low/zero interest rates fail to stimulate consumer spending and monetary policy becomes ineffective. In this situation, an increase in the money supply will fail to increase spending and investment because interest rates can't fall any further.

A liquidity trap means consumers' preference for liquid assets (cash) is greater than the rate at which the quantity of money is growing. So any attempt by policymakers to get individuals to hold non-liquid assets in the form of consumption by increasing the money supply won't work.

In the post-war period, the macro-economy was managed by changing interest rates and there was no incidence of a liquidity trap (outside Japan). However, in 2008, the global credit crunch caused widespread financial disruption, a fall in the money supply and serious economic recession. Interest rates in Europe, US and UK all fell to 0.5% - but, the interest rate cuts were very slow to cause economic activity to return to normal. 

Liquidity Trap 2009-15

In the UK, base interest rates were cut from 5% in 2008 to 0.5% in March 2009. Yet, for a considerable time, the economy remained in recession and growth remained weak. This period is a good example of a liquidity trap.


Interest rate cuts to 0.5% did little to create a strong economic recovery.


Money Supply Growth in Liquidity Trap

A feature of a liquidity trap is that increasing the money supply has little effect on boosting demand.
One reason is that increasing the money supply has no effect on reducing interest rates.

When interest rates are 0.5% and there is a further increase in the money supply, the demand for holding money in cash rather than investing in bonds is perfectly elastic.

This means that efforts to increase the money supply in a liquidity trap fail to stimulate economic activity because people save more cash reserves. It is said to be like 'pushing on a piece of string'

In the liquidity trap, there was an increase in the monetary base (due to Quantitative easing) but the broad money supply (M4) showed little increase.

M0-m4-CPI-since-05
MO (monetary base) increased by over 7% in 2009 - but, it couldn't stop the decline in M4.

See also: Explaining Paradoxes of UK economy

Why do Liquidity Traps Occur?

  • Inelastic demand for investment. In a liquidity trap, firms are not tempted by lower interest rates. The marginal efficiency of capital indicates the rate of return from investment. Usually, lower interest rates make it more profitable to borrow and invest. However, in a recession, firms don't want to invest because they expect low demand. Therefore, even though it may be cheap to borrow - they don't want to risk making investment.

  • Expectations of deflation. If there is deflation or people expect deflation (fall in prices) then real interest rates can be quite high even if nominal interest rates are zero. - If prices are falling 2% a year, then keeping cash under your mattress means your money will increase in value. The difficulty is in having negative nominal interest rates (banks would be paying you to borrow money). (There have been attempts to create a negative interest rates (e.g. destroy money in circulation but in practice, it is rarely implemented.)
  • Preference for saving. Liquidity traps occur during periods of recessions and a gloomy economic outlook. Consumers, firms and banks are pessimistic about the future, so they look to increase their precautionary savings and it is difficult to get them to spend. This rise in the savings ratio means spending falls. Also, in recessions banks are much more reluctant to lend. Also, cutting the base rate to 0% may not translate into lower commercial bank lending rates as banks just don't want to lend.
at the start of the credit crunch, there was a sharp rise in the UK saving ratio.

  • Credit Crunch. Banks lost significant sums of money in buying sub-prime debt which defaulted. Therefore, they are seeking to improve their balance sheets. They are reluctant to lend so even if firms and consumers want to take advantage of low-interest rates, banks won't lend them the money.
  • Unwillingness to hold bonds. If interest rates are zero, investors will expect interest rates to rise sometime. If interest rates rise, the price of bonds falls (see: inverse relationship between bond yields and bond prices) Therefore, investors would rather keep cash savings than hold bonds.
  • Banks don't pass base rate cuts onto consumers

In a liquidity trap, commercial banks may not pass base rate onto consumers.

How to overcome a liquidity trap

2 comments:

QP said...

"For a long time, the macro-economy was managed by changing interest rates. So it is quite a shock for policy makers to experience a situation where their main policy tool was no longer sufficient."

I would argue that their main policy tool never worked in the first place!

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