Overcoming a Liquidity Trap

see: Liquidity trap explained

Conventional economics suggests a cut in interest rates will boost spending, investment and aggregate demand. Ceteris Paribus, cuts in interest rates

• Reduce the cost of borrowing, making loans more attractive
• Reduce mortgage interest payments increasing disposable income for householders
• Make saving less attractive
• Reduce value of currency, increasing export demand.

However, in a liquidity trap, cuts in interest rates will be ineffective. A liquidity trap is a situation where zero / very low interest rates fail to stimulate consumer spending because consumers prefer to save. (e.g. because of low confidence, expectations of falling prices)

A significant cause of a liquidity trap is very low inflation rates or deflation. Deflation makes the real interest rate high and discourages spending.

Policies to Overcome a Liquidity Trap

Quantitative Easing. Quantitative easing is an attempt to increase the money balances of banks and firms. Here the Monetary authorities create money to buy assets such as government bonds. Buying bonds from financial institutions give the banks an increase in their bank balances and lowers the bond yields. In theory, this should encourage banks to increase lending. However, banks may just keep the extra money. On the other hand, if it really increases the money supply, there is a danger of inflation.

Helicopter Drop. Monetarists such as Milton Friedman have advocated bypassing financial intermediaries like banks. They argue banks may not lend their increased money supply but just hoard it and improve their balance sheets. Friedman said money could be given directly to consumers. This policy was termed a 'helicopter drop' to indicate the idea of a central bank dropping money from a helicopter. In practise it might involve something more dignified like sending a cheque in the post. If deflation is a real problem, the Central bank could give money credits which have to be spent by a certain date - to stop people just saving the extra money.

Keynesian Solution to Liquidity Trap

A Keynesian would emphasise the importance of creating positive inflationary expectations. But, would also place emphasis on the role of expansionary fiscal policy in crowding in idle resources. To offset the rise in private sector saving typical of a liquidity trap, they would advocate government borrowing to inject demand into the economy through financing investment projects.

• Liquidity trap and fiscal policy