Liquidity Trap - Meaning, Implications, Causes [UPSC Notes PDF]

By Ritesh|Updated : August 5th, 2022

A Liquidity Trap is a set of adverse economic circumstances where expansionary monetary policy fails to increase the market interest rates and income of the citizens consequently having a negative impact on overall economic growth. The Liquidity trap is an economic state when interest rates are so low or declining that an increase in the money supply has no impact on them

One major implication of the liquidity trap is when individuals hold onto their money rather than investing it or using it for other purposes. People steer clear of bonds in this scenario because they believe that interest rates will increase shortly, which would drive down bond values and result in capital losses for them. In turn, this cuts interest rates even further.

Table of Content

What is Liquidity Trap?

A liquidity trap is not only related to or restricted to economic investments and bonds. Instead, it has a significant impression on the other sides of the economy. As for businesses, they are expected to have the minimum chances of getting hired because consumers are offering the pettiest cash on products; instead, they tend to reserve that cash.

The most crucial thing to remember is the respective out-turn on stocks and bond markets to understand the liquidity trap.

  • The Liquidity Trap also significantly affects the Financing in equity because people are uncertain about the production of businesses soon or in the future. It diminishes the cash flow of these production businesses, eventually affecting the finance in the equity.
  • Seen the circumstances of a liquidity trap, ordinary people want the interest rates to rise from nil levels with time; therefore, they tend to reduce their investment in the bond charges.
  • People do not favour financing money in the market or bonds due to fear of capital losses and tend to hoard the cash as much as possible.

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Detailed Meaning of Liquidity Trap

The liquidity trap is an economic situation that arises when interest charges are null. It can also happen during a downturn in the country's economy. In these situations, ordinary people are scared or avoid spending money and believe they are safe, only holding onto the cash. And because of these circumstances, Central Banks in the country overriding expansionary budgetary policy do not improve the country's economy.

  • In simple terms, we can define a liquidity trap as a phase or situation during which the economic policies of the affected country do not effectively work.
  • Although the liquidity trap is the perseverance of economic circumstances, it is also rational as consumers choose to reserve cash instead of bonds or make significant investments due to a brushoff economic situation in the country.
  • Because bonds and interest rates are inversely related, and there is a prevailing belief that as the interest rates rise, the bond prices will decline, maximum consumers, do not seem to own such assets that are supposed to have price declination.
  • The liquidity trap in the country can be understood as the failure of monetary policies.

Monetary policies can boost the economy by reducing the interest rates to make borrowing inexpensive so that the economy strengthens or raises with the help of these investments. However, the liquidity trap can halt this managing process or tactic to manage the economy.

  • Generally, if the interest rates increase, the demand for money in the country's economy also increases, improving the income. However, in the liquidity trap, the central bank's efforts to supply more money in the market fail to increase the monetary demands. In simple words, the interest rates have declined to such a lower extent that no one is willing to invest; instead, people want to captivate all the money supplied by the central banks.
  • Therefore, there are no benefits or favourable outcomes of further reducing the interest rates.
  • A liquidity trap in a country or state is caused when people tend to reserve cash due to expecting unfavourable economic events such as depression, decline, or war in the country.
  • Recently the world economy had seen a liquidity trap during the covid 19 spread when the central banks across the globe exercised their expansionary monetary policies to respond to the crisis dropping the interest rates to nil levels.

Warnings Indicating A Liquidity Trap

Several signs are there that indicate a liquidity trap. It includes near-zero or very low-interest rates and does not give the central bank the wiggle room needed to regulate monetary policy during any crisis.

Additionally, a decline in the liquidity in the bond market is one such sign because bondholders are ready to sell bonds, but there are no buyers.

Low or near-zero interest rates:

One of the primary and significant signs indicating a liquidity trap is persistent near zero or low-interest rates for a long time as per the direction of the nation's central bank. Even though the primary purpose behind implementing such policies is to confirm a robust economy in the country, it requires close and focused monitoring; otherwise, it can turn into a liquidity trap in no time.

Declining market trends:

Predictably, a liquidity trap occurs when any country's economy is recovering from a decline. While the country's government tries to enhance economic growth with expansionary monetary policies to boost expenditure and capital investment, a conflicting effect can be seen if there is a boost in saving levels or hoarding money.

Raise in unemployment in the country:

The rolling level of unemployment in the country is one of the effects of the recession and signs of a liquidity trap. It indicates decreased income in the pocket of consumers. Because of the situation and low funds, consumers are inclined to save the surplus funds to manage future emergency expenses rather than invest or spend them. Hence, minimizing the interest rates does not bring favourable results for the revival of the country's economy.

Deflation in consumer demand:

Another sign of the liquidity trap in the country's economy is reduced consumer demand for goods and products. It leads to a fall in product prices, and consequently, the economy also falls. These trends in the market negatively affect the country's economic growth because lower consumer demands resist manufacturers from producing more products or goods in response to lower profit rates. It also hurts the country's GDP count.

Implications of Liquidity Trap

One of the foremost tips to study and understand to analyze the liquidity trap implications in a country is its respective impacts on the bond and stock market.

  • In addition to bonds and the stock market, the liquidity trap significantly impacts the investments in equity because investors are uncertain about the businesses' performance in the coming time.
  • These practices decrease the cash flow in the businesses, which brutally affects the manufacturing or production rates and eventually results in the country's GDP decline.
  • The liquidity trap also significantly impacts and favours the decline of bond investments because the interest rates and bond prices have an inverse relation.
  • Typically, bonds are correlated with a static interest scheme; therefore, the rise in the interest rates leads to investors moving toward alternative investment schemes like FDs or others.
  • Consequently, this trend lowers the bond investment demand in the market, leading to a sharp fall in bond prices.
  • During a liquidity trap, ordinary people and investors look ahead to an increase in the market interest rates from nil levels over time, which leads to a decrease in bond prices.
  • Thus, due to the fear of monetary losses, storing cash and saving capital in accounts become the primary preference instead of bond or stock investments.
  • Therefore the expansionary monetary policies are ineffective in boosting a country's economic growth; instead, they can push its economy to collapse.

Other Implications include:

  • The liquidity trap cuts the institutional interference scope.
  • The persistent slowdown decreases the stability of the macroeconomy.
  • Markets do not act in response to involvements recommending addressing deep structural problems.

How to overcome the Liquidity Trap?

Several ways can aid any economy overcome the liquidity trap and boost economic growth.

  • Though these ways do not work alone, they can effectively induce confidence in ordinary people to make expenditures and market investments again instead of saving cash or other investments.
  • Not a promising solution, but it can work well. The Federal Reserve can increase interest rates, encouraging people to invest in the market more than hoarding cash.
  • A sharp drop in product prices encourages people to spend money. It should be like people cannot resist spending money for their requirements and wants. The allure of the lowest prices can be too tempting for people, and they use their savings to take advantage of low prices.
  • The government increasing its spending can imply that it is committed to the people and confident in the country's economy. The approach can also fuel job growth in the country.
  • Governments might buy or sell bonds to aid or support controlling interest rates; however, they can only do a little in such unfavourable circumstances of the Liquidity Trap because investors are keen to sell the maximum of their bonds. Hence, it becomes somewhat challenging to push returns up or down and problematical yet to encourage investors or to take benefits of the new rate.
  • An unconventional and one of the most efficient ways to overcome the liquidity trap is quantitative easing. In this, central banks of the country purchase financial assets from other banks and organizations, leading to rising rates of those assets lowering profits, and increasing liquidity in the economy.

Liquidity Trap UPSC

The liquidity trap topic is an important topic in the UPSC syllabus. The topic is described and explained in a detailed manner in UPSC books. The UPSC aspirants must have comprehensive and detailed knowledge about this topic.

Candidates must also cover all related topics with the help of current affairs and the Economics Book for UPSC. We have also compiled Economy Notes for UPSC for comprehensive preparation.

Download Liquidity Trap UPSC Notes PDF

Liquidity Trap UPSC Prelims Sample Question

Aspirants can also take guidance from the UPSC Previous Year Question Papers. One of the examples of questions for UPSC Mains is mentioned below. Practice UPSC Answer Writing for better marks.

What is a Liquidity Trap? Describe the policies which bring the economy out of the liquidity trap in the IS-LM model.

A liquidity trap is a set of adverse economic circumstances where expansionary monetary policy fails to increase the market interest rates and income of the citizens consequently having a negative impact on overall economic growth.

Policies that can help bring the economy out of the liquidity trap:

  • The Federal Reserve can increase interest rates, encouraging people to invest in the market more than hoarding cash.
  • A sharp drop in product prices encourages people to spend money. It should be like people cannot resist spending money for their requirements and wants. The allure of the lowest prices can be too tempting for people, and they use their savings to take advantage of low prices.
  • The government increasing its spending can imply that it is committed to the people and confident in the country's economy. The approach can also fuel job growth in the country.

Governments might buy or sell bonds to aid or support controlling interest rates; however, they can only do a little in such unfavourable circumstances because investors are keen to sell the maximum of their bonds. Hence, it becomes somewhat challenging to push returns up or down and problematical yet to encourage investors or to take benefits of the new rate.

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FAQs on Liquidity Trap

  • We can define a liquidity trap as circumstances interest rate levels fall very sharply & can be near-nil and cash hoarding or other saving rates go high, leaving the expansionary monetary policies unsuccessful.

  • There is no scope that the liquidity preference can fall further. The horizontal section of this curve is the liquidity trap of any economy.

  • The liquidity trap is also rational as consumers choose to reserve cash instead of bonds or make significant investments due to a brushoff economic situation in the country.

  • Yes, quantitative easing is the most effective way to deal with the liquidity trap and its implications.

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