EFA (38): Liquidity trap

A key concept in Keynesian economics — and a possible explanation for why economies can get stuck in a recession — is the idea of a "liquidity trap". This is the subject of the 38th item in our regular Monday series, Economics for Amateurs (EFA).

But what exactly is a liquidity trap? In fact, the term is now used in a number of ways that are related but not identical.

To understand the basic concept, imagine that the government wants to encourage borrowing and spending to help the economy get out of a recession. One way to do this would be to reduce the level of interest rates. And one way to achieve this aim would be to use monetary policy.

Specifically, the government could increase the supply of money (basically, notes and coins plus bank deposits). An increase in the money supply normally causes interest rates to fall, in the same way that an increase in the supply of any good leads to a fall in its price. (Interest rates can be seen in this context as being the "price" of money.)

In some situations, however, this method doesn't work. Instead, individuals and firms are quite happy to hold the extra supply of money, even without a fall in interest rates. In economic jargon, the demand for money is "perfectly elastic" with respect to the interest rate.

In such a situation, the economy can get trapped at less than full employment because the government is powerless to reduce interest rates through monetary policy.

This situation does not necessarily imply that interest rates are zero. There could, for example, be a liquidity trap, with interest rates stuck at, say, one or two percent. Recently, however, the term "liquidity trap" has often been used to describe a situation in which nominal interest rates are zero, which means that governments cannot reduce them any further.

Another situation that is now sometimes called a liquidity trap — incorrectly, some experts would say — is when banks refuse to increase their lending even though they have acquired extra reserves.

We had an example of such a situation last week, when Germany's chancellor Angela Merkel called on the country's banks to lend more to business. The German government had become frustrated that banks were not lending enough — thus causing a "credit crunch", or "credit squeeze" — in spite of government help to improve their balance sheets.