Tuesday, April 17, 2012

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 (financial instrument) 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. 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.

Interest rates are very low, and consumers nevertheless prefer to save rather than spend or invest in higher-yielding bonds or other investments.
Consumers choose to hoard cash instead of choosing higher-yielding investments because of a negative economic outlook.
Not limited to bonds, a liquidity trap also affects other areas of the economy = as consumers spend less, which can mean businesses are less likely to hire.
A liquidity trap mutes monetary policy efforts to stimulate growth because interest rates are already at or close to zero, thus perpetuating recession.
Escaping a liquidity trap? Raising interest rates; self-regulation as prices fall to attractive levels; increased government spending.

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