What is the 'Liquidity Trap'

The liquidity trap is the situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings because of the prevailing belief that interest rates will soon rise. Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline.

BREAKING DOWN 'Liquidity Trap'

Should the regulatory committee try to stimulate the economy by increasing the money supply, there would be no effect on interest rates, as people do not need to be encouraged to hold additional cash.

As part of the liquidity trap, consumers continue to hold funds in standard deposit accounts, such as savings and checking accounts, instead of in other investment options, even when the central banking system attempts to stimulate the economy through the injection of additional funds. These consumer actions, often spurred by the belief of a negative economic event on the horizon, causes monetary policy to be generally ineffective.

Signs of the Liquidity Trap

One marker of a liquidity trap is particularly low interest rates. These low interest rates can affect bondholder behavior, along with other concerns regarding the current financial state of the nation, resulting in the selling of bonds in a way that is harmful to the economy. Further, additions made to the money supply fail to result in price level changes, as consumer behavior leans toward saving funds into lower-risk and highly liquid mechanisms. Without changes to interest rates, consumers are not motivated to invest into other options.

Low interest rates alone do not define a liquidity trap. For the situation to qualify, there has to be a lack of bondholders wishing to keep their bonds and a limited supply of investors looking to purchase them. Instead, the investors are prioritizing strict cash savings over bond purchasing. If investors are still interested in holding or purchasing bonds at times when interest rates are low, even approaching the zero limit, the situation does not qualify as a liquidity trap.

Lenders and Borrowers

A notable issue of a liquidity trap involves financial institutions having problems finding qualified borrowers at a particular level. This is compounded by the fact that, with interest rates approaching zero, there is little room for additional incentive to attract well-qualified candidates. This lack of borrowers often reflects lower buying behavior, such as that related to higher priced, and often financed, purchases such as cars and homes.

Curing the Liquidity Trap

There are a number of ways to help the economy come out of a liquidity trap:

  1. The Federal Reserve can raise interest rates, which may lead people to invest more of their money, rather than hoard it. 
  2. A (big) drop in prices. When this happens, people just can't help themselves from spending money. 
  3. Increasing government spending. When the government does so, it implies that the government is committed and confident in the national economy. This tactic also fuels job growth.
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