You may have heard of something called a liquidity trap. No, it is not the time during the summer season when you are desperate for a drink and cannot get it anywhere. This is a situation in a nation's economy where everyone hoards money. The citizens do not want to invest or spend it. This condition takes place when the interest rates become zero or when there is a recession. The citizens are quite afraid to spend any money, so they keep holding on to their cash. Because of this, central banks use expansionary monetary policy, which does not boost the economy. When there is such a liquidity trap, the economy of the nation may go into recession. This can also lead to deflation. When deflation continues for a long time, it can lead to the real interest rates increasing. This harms investment and also broadens the output gap. The economy then goes into a vicious cycle. If the recession is also constant, deflation reduces the output. Thus, the monetary policy of the central bank becomes quite ineffective.
The central banks manage the liquidity present in a nation using monetary policy. This main tool is to lower the interest rates, which helps to boost borrowing. This makes loans quite cheap and encourages firms and families to borrow so that they can spend and invest. It is equivalent to stepping on the accelerator to increase the speed of the engine. When the gas pedal is pushed, the speed of the car increases. A liquidity trap often happens after there has been a major recession. Firms and families are quite afraid to spend no matter how much credit is present. It is just like a flooded car engine.
The engine releases so much gas that it crowds out the oxygen in it. At that point, it does not help to pump the gas pedal. This is exactly what takes place in a liquidity trap. The gas of the Federal Reserve is credit, and the accelerator is lower interest rates. When the Federal Reserve pushes the gas pedal, it does not increase the economic engine. Instead, the families and firms hoard that cash. They do not have the confidence to spend it. Thus, they do not do anything with it. In this case, the economic engine is flooded.
Various signs show that a country has reached such a stage trap. These signs are good proof that the initiatives taken by the nation's central bank to increase money circulation through borrowing and spending in the economy are not fructifying as they would like. The first sign is that during a recession, the citizens are not so confident and do not think about borrowing any money. Financial institutions utilize the extra money to write down bad debts or increase their capital to safeguard against any probable bad debt. They may even try to increase their requirements for lending. The next sign is that the lower rates of interest do not cause any increase in the overall spending by the citizens in the economy. The financial institutions look to take the extra money infused into the national economy by the central banks and give it out through various channels of loans such as credit cards, small business loans, and mortgages.
The following sign is that the firms do not spend the extra money. The firms do not take the benefits of the interest rates that have been lowered and avoid any kind of expansion activities. Instead, they utilize it to buy back their shares so that they can increase the prices of their shares. They also do not try to buy any new equipment or devices for their factories or offices. They try to continue with their present infrastructure. They may also try to buy new firms in acquisitions or mergers or go for leveraged buyouts. These activities boost the financial markets but not a nation's economy. Another sign is that the wages do not increase. This is because the firms are also quite reluctant to utilize the extra funds to get new workers. As an outcome, the wages remain constant. Without an increase in income, families only purchase what they require and save the rest. This led to a lack of demand.
Yet another sign pointing toward this condition is that consumer prices remain at a low level. Usually, when the Federal Reserve tries to boost the overall monetary supply in the economy, it leads to inflation. In terms of a liquidity trap, there may be falling prices or deflation. So, people delay purchasing things because they think the prices will be even lower. The final factor is low-interest rates. The interest rates must be at rock bottom for a liquidity trap to occur. If that condition persists for some time in the economy, individuals believe that the interest rates will only go up. When that happens, there is no person that wants to purchase bonds. This is because a bond that pays low-interest rates today will not be as valuable after the interest rates rise. Every person will want to buy bonds when the interest rates are higher because it will give higher returns. This will make the present bonds of much lower value.
We hope that you now associate this term with something other than the thought of drinking lemonades in hot summers. A liquidity trap happens when the interest rates become so low that holding on to money is the same as purchasing debt instruments. There are several ways out of any such liquidity trap. The best way is for the central bank to increase the interest rates to boost savings and the federal government to spend more to infuse more confidence in the economy.