Macroeconomics

‭The Liquidity Trap‬ ‭While‬ ‭it's‬ ‭generally‬ ‭expected‬ ‭that‬ ‭an‬‭increase‬‭in‬‭the‬ ‭money‬ ‭supply‬ ‭would‬ ‭lead‬ ‭to‬ ‭a‬ ‭reduction‬ ‭in‬ ‭the‬ ‭nominal‬‭interest‬‭rate,‬‭according‬‭to‬‭Keynes,‬‭this‬‭does‬ ‭not‬ ‭always‬ ‭hold‬ ‭true.‬ ‭A‬ ‭liquidity‬ ‭trap‬ ‭is‬ ‭a‬ ‭situation‬ ‭where‬ ‭increasing‬ ‭the‬ ‭money‬ ‭supply‬ ‭cannot‬ ‭lower‬ ‭the‬ ‭interest‬ ‭rate‬ ‭.‬ ‭Keynes‬‭described‬‭this‬‭scenario‬‭as‬ ‭occurring‬ ‭when‬‭interest‬‭rates‬‭are‬‭already‬‭very‬‭low,‬ ‭and‬ ‭bond‬ ‭prices‬ ‭are‬ ‭very‬ ‭high‬ ‭.‬ ‭In‬ ‭such‬ ‭cases,‬ ‭speculators‬‭anticipate‬‭that‬‭bond‬‭prices‬‭will‬‭fall‬‭in‬‭the‬ ‭future,‬‭leading‬‭them‬‭to‬‭hoard‬‭the‬‭extra‬‭money‬‭rather‬ ‭than‬‭purchasing‬‭bonds‬‭out‬‭of‬‭fear‬‭of‬‭incurring‬‭capital‬‭losses,‬‭and‬‭because‬‭the‬‭returns‬‭from‬‭holding‬‭such‬ ‭securities are minimal.‬

‭Notice‬ ‭how‬ ‭the‬ ‭initial‬ ‭increase‬ ‭in‬ ‭money‬ ‭supply‬ ‭from‬ ‭Ms‬ ‭to‬ ‭Ms₁‬ ‭led‬ ‭to‬ ‭a‬ ‭reduction‬ ‭in‬ ‭the‬ ‭equilibrium‬ ‭interest‬ ‭rate‬ ‭at‬ ‭point‬ ‭Z.‬ ‭However,‬ ‭a‬ ‭further‬ ‭increase‬ ‭at‬ ‭very‬ ‭low‬ ‭interest‬ ‭rate‬ ‭levels‬ ‭(from‬‭Ms₁‬‭to‬‭Ms₂),‬‭where‬‭the‬‭demand‬‭for‬‭money‬‭is‬ ‭horizontal‬ ‭(perfectly‬ ‭elastic),‬ ‭did‬ ‭not‬ ‭further‬ ‭decrease‬ ‭the‬ ‭interest‬ ‭rate.‬ ‭The‬ ‭concept‬ ‭of‬ ‭a‬ ‭liquidity‬ ‭trap‬ ‭is‬ ‭essential‬ ‭for‬ ‭assessing‬ ‭the‬ ‭effectiveness‬ ‭of‬‭monetary‬‭policy‬‭because‬‭when‬ ‭interest‬ ‭rates‬ ‭are‬ ‭already‬ ‭very‬ ‭low,‬ ‭it‬ ‭may‬ ‭no‬ ‭longer‬ ‭be‬ ‭benefcial‬ ‭to‬ ‭push‬ ‭them‬ ‭lower‬ ‭.‬ ‭As‬ ‭a‬ ‭result,‬‭this‬‭particular‬‭policy‬‭tool‬‭may‬‭cease‬‭to‬‭be‬‭a‬ ‭viable option.‬

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