Liquidity Trap Defined: A Keynesian Economics Concept

The liquidity trap is a situation defined in Keynesian economics, the brainchild of British economist John Maynard Keynes (1883-1946). Keynes ideas and economic theories would eventually influence the practice of modern macroeconomics and the economic policies of governments, including the United States.

Definition

A liquidity trap is marked by the failure of injections of cash by the central bank into the private banking system to decrease interest rates. Such a failure indicates a failure in monetary policy, rendering it ineffective in stimulating the economy. Simply put, when expected returns from investments in securities or real plant and equipment are low, investment falls, a recession begins, and cash holdings in banks rise. People and businesses then continue to hold cash because they expect spending and investment to be low creating is a self-fulfilling trap. It is the result of these behaviors (individuals hoarding cash in anticipation of some negative economic event) that render monetary policy ineffective and create the so-called liquidity trap.

Characteristics

While people’s saving behavior and the ultimate failure of monetary policy to do its job are the primary marks of a liquidity trap, there are some specific characteristics that are common with the condition. First and foremost in a liquidity trap, interest rates are commonly close to zero. The trap essentially creates a floor under which rates cannot fall, but interest rates are so low that an increase in the money supply causes bond-holders to sell their bonds (in order to gain liquidity) at the detriment to the economy. The second characteristic of a liquidity trap is that fluctuations in the money supply fail to render fluctuations in price levels because of people’s behaviors.

Criticisms

Despite the ground-breaking nature of Keynes ideas and the world-wide influence of his theories, he and his economic theories are not free from their critics. In fact, some economists, particularly those of the Austrian and Chicago schools of economic thought, reject the existence of a liquidity trap altogether. Their argument is that the lack of domestic investment (particularly in bonds) during periods of low interest rates is not a result in people’s desire for liquidity, but rather badly allocated investments and time preference.

Further Reading

To learn about important terms related to the liquidity trap, check out the following:

• Keynes Effect: A Keynesian economics concept that essentially disappears in the wake of a liquidity trap
• Pigou Effect: A concept that describes a scenario in which monetary policy could be effective even within the context of a liquidity trap
• Liquidity: The primary behavioral driver behind the liquidity trap