Liquidity trap

A liquidity trap is a situation, described in Keynesian economics, in which, 'after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest.'There is the possibility...that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto.A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes.The view that the liquidity-preference function is a demand-for-money relation permits the introduction of the idea that in appropriate circumstances the demand for money may be infinitely elastic with respect to variations in the interest rate… The liquidity trap presumably dominates in the immediate aftermath of a great depression or financial crisis. A liquidity trap is a situation, described in Keynesian economics, in which, 'after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest.' A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. According to mainstream theory, among the characteristics of a liquidity trap are interest rates that are close to zero and changes in the money supply that fail to translate into changes in the price level. John Maynard Keynes, in his 1936 General Theory, submitted the following: This concept of monetary policy's potential impotence was first suggested in the works of British economist John Hicks, inventor of IS–LM modeling. In fact, Nobel laureate Paul Krugman, in his work on monetary policy, follows the original formulations of Hicks: There is an obvious difference between the two definitions: In the latter, mainstream definition of a liquidity trap, people are indifferent between bonds and cash because the rates of interest both financial instruments provide to their holder is practically equal: The interest on cash is zero and the interest on bonds is near-zero. Hence, the central bank cannot affect the interest rate any more (through augmenting the monetary base) and has lost control over it. In Keynes' description of a liquidity trap, people simply do not want to hold bonds and prefer other, non-liquid forms of money instead. Because of this preference, after converting bonds into cash, this causes an incidental but significant decrease to the bonds' prices and a subsequent increase to their yields. However, people prefer cash no matter how high these yields are or how high the central bank sets the bond's rates (yields). Post-Keynesian economist Hyman Minsky posited that 'after a debt deflation that induces a deep depression, an increase in the money supply with a fixed head count of other assets may not lead to a rise in the price of other assets.' This naturally causes interest rates on assets that are not considered 'almost perfectly liquid' to rise. In which case, as Minsky had stated elsewhere, In the wake of the Keynesian revolution in the 1930s and 1940s, various neoclassical economists sought to minimize the effect of liquidity-trap conditions. Don Patinkin and Lloyd Metzler invoked the existence of the so-called 'Pigou effect', in which the stock of real money balances is ostensibly an argument of the aggregate demand function for goods, so that the money stock would directly affect the 'investment saving' curve in IS/LM analysis. Monetary policy would thus be able to stimulate the economy even when there is a liquidity trap. Monetarists, most notably Milton Friedman, Anna Schwartz, Karl Brunner, Allan Meltzer and others, strongly condemned any notion of a 'trap' that did not feature an environment of a zero, or near-zero, interest rate across the whole spectrum of interest rates, i.e. both short- and long-term debt of the government and the private sector. In their view, any interest rate different from zero along the yield curve is a sufficient condition to eliminate the possibility of the presence of a liquidity trap.