Liquidity trap
A liquidity trap occurs when nominal rates are near zero and additional money is held as cash, so monetary easing fails to raise spending. It builds on Keynes and liquidity preference. Deflation expectations can raise real rates. Krugman (1998) analysed Japan’s slump this way; many central banks hit the lower bound after 2008. Responses include fiscal stimulus, quantitative easing, forward guidance (Eggertsson & Woodford, 2003) and negative rates.
Frequently asked questions
- Why can’t rates go lower?
- People can hold cash, limiting how far below zero rates can go.
- What works in a liquidity trap?
- Fiscal policy, plus QE and forward guidance.
References
- Keynes, J. M. (1936). The general theory of employment, interest and money. Macmillan.
- Krugman, P. R. (1998). It’s baaack: Japan’s slump and the return of the liquidity trap. Brookings Papers on Economic Activity, 1998(2), 137–205.
- Eggertsson, G. B., & Woodford, M. (2003). The zero bound on interest rates and optimal monetary policy. Brookings Papers on Economic Activity, 2003(1), 139–211.