Liquidity trap
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A liquidity trap is a situation, described in
A liquidity trap is caused when people hold cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. 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.[2]
Origin and definition of the term
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.
This concept of
Elaboration
In Keynes' description of a liquidity trap, people simply do not want to hold bonds and prefer other, more-liquid forms of money instead. Because of this preference, after converting bonds into cash,[note 3] 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).[6]
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
Historical debate
In the wake of the
In recent times, when the Japanese economy
Some
Keynesian economists, like Brad DeLong and
Global financial crises of 2008 and 2020
During the
Modest inflation during the COVID-19 crisis in 2020, despite unprecedented monetary stimulus and expansion, was similarly ascribed to hoarding of cash.
Post-Keynesians respond[22] that the confusion by "mainstream economists" between conditions of a liquidity trap, as defined by Keynes and in the Post-Keynesian framework, and conditions of near-zero or zero interest rates, is intentional and ideologically motivated in ostensibly attempting to support monetary over fiscal policies. They argue that, quantitative easing programs in the United States, and elsewhere, caused the prices of financial assets to rise across the board and interest rates to fall; yet, a liquidity trap cannot exist, according to the Keynesian definition, unless the prices on imperfectly safe financial assets are falling and their interest rates are rising.[23] The rise in the monetary base did not affect interest rates or commodity prices.[24]
Taking the precedent of the Global Financial Crisis of 2008, critics[25] of the mainstream definition of a liquidity trap point out that the central bank of the United States never, effectively, lost control of the interest rate. Whereas the United States did experience a liquidity trap in the period 2009/10, i.e. in "the immediate aftermath" of the crisis,[note 6] the critics of the mainstream definition claim[22] that, after that period, there is no more of any kind of a liquidity trap since government and private-sector bonds are "very much in demand".[6] This goes against Keynes' point as Keynes stated that "almost everyone prefers cash to holding a debt."[1] However, modern finance has the concept of cash and cash equivalents; Treasuries may in some cases be treated as cash equivalents and not "debt" for liquidity purposes.[26]
See also
- Speculative bubble
- Subprime mortgage crisis
- Too big to fail
- Zero interest rate policy
- Inverted yield curve
Notes
- ^ The model depicts and tracks the intersection of the "investment–saving" (IS) curve with the "liquidity preference–money supply" (LM) curve. At the intersection, according to the mainstream, Neo-Keynesian analysis, simultaneous equilibrium occurs in both interest and financial-assets markets
- ^ Hicks, subsequently and a few years before his passing, repudiated the IS/LM model, describing it as an "impoverished" representation of Keynesian economics. See Hicks (1981)
- ^ Whereby "cash" includes both currency and bank accounts, aka M1
- ^ See "Monetarism and the liquidity trap
- ^ The assumption being that no one would lend 100 dollars unless they were to get at least 100 dollars back, although we have seen in the 21st century the introduction, without any problem in demand, of negative interest-rates. See e.g. "Why negative interest rates sometimes succeed" by Gemma Tetlow, Financial Times, 5 September 2016
- Fed intervention, as demonstrated by the TED spread history. See TED ratefor the period 2007/16
References
- ^ ISBN 978-0-230-00476-4
- ^ Krugman, Paul R. (1998) "It's baack: Japan's Slump and the Return of the Liquidity Trap," Archived 24 May 2013 at the Wayback Machine BrookingsPapers on Economic Activity
- ISBN 9780321552075.
- ^ Hicks, John R. (1937) "Mr Keynes and the Classics: A Suggested Interpretation", Econometrica, Vol. 5, No. 2, April 1937, pp. 147-159
- ^ Krugman, Paul R. (14 July 2010). "Nobody Understands The Liquidity Trap". The New York Times.
- ^ Pilkington, Philip (2014) "Paul Krugman Does Not Understand the Liquidity Trap", Naked Capitalismwebsite, 23 July 2014
- ISBN 978-0-07-159299-4
- ISBN 978-0-07-159301-4
- JSTOR 591.
- ^ Metzler, Lloyd (1951) "Wealth, Saving and the Rate of Interest", Journal of Political Economy, 59(2), pp. 93-116
- JSTOR 2226394.
- ^ Antonopoulou, Sophia N. (2009) "The Global Financial Crisis", The International Journal of Inclusive Democracy, Vol. 5, No. 4 / Vol. 6, No. 1, Autumn 2009/Winter 2010
- ^ Crafts, Nicholas (12 May 2013). "Escaping liquidity traps: Lessons from the UK's 1930s escape". CEPR. Retrieved 2 March 2018.
- The Mises Institute, 13 May 2003
- ^ Sumner, Scott (25 March 2011). "Why Japan's QE didn't 'work'". The Money Illusion website. Retrieved 3 June 2011.
- ^ Krugman, Paul R. (9 October 2011). "IS-LMentary". The New York Times.
- ^ Krugman, Paul R. (7 January 2017). "The Shock of the Normal". The New York Times.
- ^ Krugman, Paul R. (17 March 2010) "How much of the world is in a liquidity trap?", The New York Times
- ^ Krugman, Paul R. (7 October 2011). "Way Off Base". The New York Times.
- ^ Sumner, Scott (11 September 2010). "The other money illusion". The Money Illusion website. Retrieved 3 June 2011.
- ^ Maria A. Arias; Yi Wen (April 1, 2014). "The Liquidity Trap: An Alternative Explanation for Today's Low Inflation". St. Louis Federal Reserve. Retrieved October 25, 2021.
- ^ Pilkington, Philip (2013) "What is a Liquidity Trap?", Fixing the economists website, 4 July 2013
- ^ Mitchell, William (2012) "The on-going crisis has nothing to do with a supposed liquidity trap", 28 June 2012
- ^ Wray, L. Randall (2013) "Reconciling the Liquidity Trap With MMT: Can DeLong and Krugman Do the Full Monty With Deficit Owls?", Economonitor, 1 May 2013
- ^ Roche, Cullen (2014) "Would Keynes Have Called this a “Liquidity Trap”?", Pragmatic Capitalism website, 23 March 2014
- S2CID 212969994.
Further reading
- Boianovsky, Mauro (2003). "The IS-LM Model and the Liquidity Trap Concept: from Hicks to Krugman" (PDF). History of Political Economy, Duke University Press. Archived from the original (PDF) on 2017-08-29. Retrieved 2017-10-16.
- Eggertsson, Gauti H. (2008). "Liquidity Trap" (2nd ed.). The New Palgrave Dictionary of Economics Online.
- Hicks, John R. (1981) "IS-LM: An Explanation", Journal of Post Keynesian Economics, Volume 3, 1980, Issue 2