How Does Liquidity Trap Happen And How To Avoid It

The liquidity trap is a phenomenon that happens when governmental policies fail to recover a declining economy using traditional policies. The economy is a complex system, and its participants, including buyers, sellers, and marketplaces, are interconnected.

Therefore, one change in these factors can significantly impact the rest and, eventually, the whole economy. During economic uncertainty, authorities change their monetary policies to stimulate the economy using traditional methods like changing the interest rates or the money supply. 

Parallel with the governmental failing attempts, people tend to hold their money and decrease spending. The public may also stop their investments and withdraw money from the banks and financial markets.

Definition Of Liquidity Trap

During an economic crisis, central banks may implement monetary and fiscal changes to incentivise the public to spend and invest money. However, when these methods become ineffective, and people still prefer hoarding cash, this is called a liquidity trap.

In such times, central banks try to incentivise the public by lowering interest rates to encourage borrowing and spending. Additionally, governments may engage in market activity to increase the money supply in the economy.

These attempts fail because the public does not see the point of investing with very low interest rates, while others wait for the rates to increase again before they invest.

On the other hand, engaging in market activity and increasing the money supply might not bring the expected results because it will eventually lead to lower interest rates, which is again ineffective. 

Therefore, new solutions must be discovered to stimulate the economy and motivate the public to spend and invest.

How To Identify a Liquid Trap

There are several symptoms of a declining economy, such as inflation rates and general output. However, you can find the following characteristics in an economy facing a liquidity trap.

Interest Rate

When an economy faces a liquidity trap or any other economic instability, lowering the interest rates is a usual practice. Decreasing the interest rates can incentivise the public to take low-cost loans and increase spending. 

However, people will most likely keep holding their liquid assets – cash – as they do not see enough profit in investing when the interest rates are low. Therefore, other solutions need to be discovered and implemented.

Investment Activity

In times of economic crisis, people tend to hold on to their money in cash because they are uncertain about the future, and they prefer to withdraw their money from the market and stop any investing activity.

Therefore, a significant amount of money is withdrawn from the financial markets, leading to a steady decline in the economy’s growth rate.

When there is public fear of ongoing economic instability, people usually do not trust their banking systems and prefer to invest their money in other economies outside their country.

Inflation Level

The liquidity trap and the lack of investment and market activity lead to an overall decline in the growth rate, and the inflation rate starts falling below 0%, which is called deflation.

Deflation happens when the spending level and money circulation are too low, and the demand in the market dramatically falls. Eventually, everyone is holding their money, which is the case of the liquidity trap.

Monetary & Fiscal Policies

The government’s traditional monetary and fiscal policies during economic meltdowns usually bring no results. Central banks might become unable to decrease the interest rate below zero or dramatically increase the money supply, which may cause the currency to collapse.

Therefore, policymakers need to come up with new solutions that drive the market demand and incentivise the public to invest and let go of their cash holdings.

Economy Indicators

Economic indicators start to show negative trends during a liquidity trap, such as a falling growth rate, low gross domestic product, and high unemployment rate.

The liquidity trap surely damages the economy, and if it persists for a longer period of time, it may lead to a severe economic collapse. 

Tips To Prevent

There is no clear-cut plan to cure the liquidity trap since it is caused by a rather complex set of reasons. However, few steps can mitigate and prevent this phenomenon from happening.

• Increase the interest rate and motivate the public to invest their money.
• Undertake massive price drops to encourage spending and increase liquidity in the market.
• Quantitative Easing: Increase governmental spending by engaging in the financial market and injecting more money into circulation.
• Implement a negative interest rate policy if the high rates do not attract the public. Thus, people can take loans at extremely low rates, stimulating spending. 

Conclusion

The liquidity trap happens when policymakers fail to stimulate economic growth, and the public does not respond to governmental efforts. Instead, people prefer holding their cash and reducing their spending and investment.

Since it is a rare occurrence, the usual monetary and fiscal policies fail to solve this problem and special methods are required to cure it and restore the economy.