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What is a Liquidity Trap?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 13 September 2016
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Liquidity traps are financial situations where a factor that usually stimulates the economy fails to achieve the desired reaction. One example of a liquidity trap is when a drop in interest rates fails to motivate consumers to purchase more goods and services on credit. The trap may also develop when a majority of financial assets are tied up in non-liquid accounts, making it difficult or impossible to convert those non-liquid resources into liquid assets that can be used for new purchases or acquisitions.

John Maynard Keynes is often identified as the inventor of the concept of a liquidity trap. Keynes first developed this theory during the middle of the Great Depression in the United States during the mid-1930’s. Essentially, Keynes pointed to the events of recent years and noted how the events leading up to the Stock Market Crash of 1929 and the prevailing attitudes of both lenders and borrowers during the Depression created a situation where the usual economic stimulators were not creating the desired effect.

Even when an economic depression is not taking place, it is possible for a liquidity trap to emerge. When consumers suspect that interest rates are likely to fall below current levels, they may choose to avoid incurring new debt for a period of time. This is true even if interest rates have recently fallen. As long as there is the expectation that rates will fall even further, consumers will refrain from borrowing money or making major purchases.

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Another approach to the liquidity trap focuses on lenders rather than consumers. When lenders perceive that the usual indicators in monetary economics point toward an increase in defaults on loans and credit accounts, they may become highly selective in writing new debt. This means that consumers who normally are able to obtain credit with relative ease are suddenly unable to get credit even with higher interest rates.

Rates of interest on savings accounts often are relatively high during a liquidity trap, while the interest rates on loans and credit cards are low. Along with suspecting that the interest rates on credit accounts may go lower, consumers may also want to divert liquid assets into savings accounts and take advantage of the high interest on those accounts while they can. This combination of circumstances further motivates consumers to save rather than spend.

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stoneMason
Post 3

Liquidity trap actually has a lot to do with public trust. If people trust the economy and politics, then they are more likely to spend and take loans. But if people feel that the economy or politics are unstable, they won't do it. At least, that's how I see it.

ddljohn
Post 2

@ZipLine-- I'll try.

Expansionary fiscal policies are government policies used to stimulate the economy. The government may increase spending or reduce taxes to leave consumers more money to spend. As people spend, the economy is stimulated and economic downturn and recession can be prevented.

A liquidity trap due to fiscal policy mainly has to do with greater government spending. What happens is that the government spends more money expecting people to buy more and stimulate the economy. But instead of purchasing, people save the money to prepare for worse economic conditions. This is called a liquidity trap. It basically means that the money spent has gone to waste because the policy failed to stimulate the economy.

This type of liquidity trap often occurs during recession and it has happened several times in US history.

ZipLine
Post 1

I need to learn about liquidity traps due to expansionary fiscal policies. Can anyone help me out?

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