7.1 Liquidity trap

One situation in which the market does not function as usual is the so-called liquidity trap. Here, interest rates are so low that it is not possible to expand the money supply by lowering interest rates. The graphic illustrates this in the IS-LM model. In the normal situation, the LM curve slopes upwards at the equilibrium point GG (intersection IS and LM). In the liquidity trap, however, IS and LM curve intersect at a flat spot of the LM curve. This situation can occur if, for example

- the IS curve is shifted so far to the left due to a crisis (e.g. economic slump, decrease of domestic demand, decrease of export demand, cuts by the government, austerity policy, ...) or

- due to very expansive monetary policy (e.g. to avert an economic crisis, etc.) the LM curve is shifted so far to the right.

If the shift is caused by an expansive monetary policy, it ends as soon as the intersection reaches the flat part of the LM curve, usually when the interest rate is 0. In order to increase the money supply even further, exceptional measures must be taken: "quantitative easing".

This phenomenon was first economically analyzed and named by John Maynard Keynes. He described the liquidity trap as a state of the economy in which an expansion of the money supply does not lead to a decrease of the interest rates, i.e. the causality of interest rate and money supply is viewed inversely. Keynes presents an economy in an equilibrium at underemployment and depicts the situation between the world wars. He propagates expansive fiscal and monetary policy without having to fear crowding-out or interest rate increases (investment decline). Rather, such fiscal policy measures act as an initial spark, as they have a major impact thanks to the multiplier effect, while monetary policy measures end up in the liquidity trap.

Theoretical presentation
In more recent textbooks, the liquidity trap is described as a situation with an infinitely interest-elastic money demand. Every additional supply of money is in demand and held in the so-called speculative treasury. Therefore, the increase in money supply does not take effect in the economic cycle. Economic actors neither consume the additional liquidity (there has not been a transfer of assets, but only a supply of credits by the central bank) nor do they invest it, since they have to expect stock losses of fixed-interest bonds when interest rates rise and this risk of loss is not offset by interest revenues.
Practical relevance
While the theoretical analysis postulates a complete absorption in the speculative treasury of any amount of money supplied, in reality this is limited. On the one hand, even with an interest rate of 0, it is not possible to receive an unlimited amount of basis money from the central bank, since the banks have to deposit securities. Thus, the amount of available securities limits the amount of money demanded and not, as is usually the case, the interest rate. On the other hand, in reality the interest rates are usually not at 0, but still slightly positive (for example the TLTRO of the ECB of September and December 2014 with 0.15% over 4 years). Thus, borrowing central bank money without a lucrative investment opportunity would be unprofitable for a commercial bank.

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743
E-mail: Bauer@uni-trier.de
URL: https://www.cbauer.de