We do come across liquidity traps in our real life. Think of a situation: You have inserted a coin into a vending machine, but the goodies lying inside are not coming out. The machine has just eaten your precious coin. It’s a kind of liquidity trap. Sometimes, the entire economy may behave like a vending machine gone haywire. In such a situation, despite the efforts of the central bank to put in more money, the economic chain hardly shows any sign of movement. A liquidity trap is the worst possible nightmare for an economy.
Johnny: Can you explain what exactly a liquidity trap is?
Jinny: The term liquidity trap was coined by John Maynard Keynes to describe a situation in which increase in money supply has no effect on increase in aggregate demand for goods and services, as a result of which an economy is unable to come out of a recession. During the spell of a liquidity trap, no one spends money even when the central bank has reduced the nominal interest rates to zero.
The common wisdom is that an increase in money supply or lower interest rates should encourage people to buy more goods and services, which in turn should encourage economic growth. But in a classic liquidity trap, everybody becomes a prisoner of money—no demand, no growth and no inflation—all negative things just keep on piling.
Illustration: Jayachandran / Mint
You might, in fact, see falling prices in the midst of a sea of liquidity, which makes the recession even more severe. Since the nominal interest rate is already close to zero, any further increase in money supply can hardly make any difference. Nominal interest rates can’t be pushed below zero because that would defy common sense. Nobody would lend Rs100 if they are going to get only Rs95 in return.
Johnny: It surely looks unusual. Can you explain how and why an economy might fall into a liquidity trap?
Jinny: Well, the Keynesian idea of a liquidity trap was shaped during the experiences of the Great Depression of the 1930s, but we have also seen a Japanese-style liquidity trap during the 1990s. The debate is still on, on whether the US economy could have fallen into another liquidity trap after the subprime-led recession. There are some patterns that we should keep in mind.
First, an economy going through a recession after the bursting of a bubble is more likely to fall into a liquidity trap. Bigger shocks to the financial system can’t be simply cured by more money supply. A point comes when all the efforts of the central bank to pump money supply fail to stir any borrowing or spending, as if something were really blocking the pipes.
Second, an economy already in the grip of negative expectations is more likely to fall into a liquidity trap. When prices are falling, people expect that they would continue to fall. When one company goes bankrupt, they expect that other companies would also go bankrupt. People expect the possibility of suffering real loss by spending or investing their money now, which makes them hold their money, a sure-shot recipe for a liquidity trap.
Johnny: How can we deal with a liquidity trap?
Jinny: Some of the suggested cures look stranger than the problem. One suggestion is that we impose tax on people holding cash. So if you are not spending or investing money, then you would have to pay a tax. Some even suggest that we put an expiry date on money so that after some time, the money lying in your pocket would cease to be accepted as money. In short, these solutions look like asking people to spend their money at gunpoint. Not so easy to implement.
There are other, less dramatic suggestions too. For instance, the traditional Keynesian model of using fiscal stimulus for stirring aggregate demand in the economy can help in coming out of a liquidity trap, but as the experience of Japan shows, even this may not always work.
So is there any other solution in our arsenal? Yes, there is. The traditional route for a central bank to increase money supply is to buy government securities. Whenever the central bank buys government securities, it has to pay the price of securities, which increases the money supply. Generally, the buying of government securities is a matter between the central bank and financial institutions.
The money supply so created would have an effect on prices of other goods and services only when the money starts moving around. But in a liquidity trap, this does not happen. To overcome this, the central bank tries to inject money by unconventional routes, by buying other assets—maybe commercial bills, non-government securities, scrap metal or just about anything which puts money directly in the hands of people.
Ben Bernanke, the current chairman of the US Federal Reserve, once talked about using helicopters for dropping money. This strategy could be closest to what we know as helicopter money.
Johnny: Well, I am not sure whether this strategy would always work, but it seems worth a try.
What:A situation in which an increase in money supply has no effect on the aggregate demand for goods and services is called a liquidity trap.
Why: An economy may fall into a liquidity trap due to many reasons—such as recent shocks to the financial system and negative expectations of people, among others.
Who: The term liquidity trap was coined by John Maynard Keynes.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org