Answer to Question #118482 in Macroeconomics for brilltod

Question

Discuss the concept of liquidity trap and its implications on the conduct of monetary policy in an economy.

Answer 1

A liquidity trap refers to an economic situation where people hoard financial capital. Instead of investing or spending. Due to this the central bank will not use expansionary monetary policy to boost the economic growth.

This occurs when short-term interest rates are zero.

A liquidity trap is caused by the following reasons.

Central banks are in charge of managing liquidity with monetary policy. Their primary tool is to lower interest rates to encourage borrowing. This makes loans inexpensive therefore encouraging business people to borrow in order to invest and spend.

Bearing in mind that the United States central bank is the Federal Reserve. It lowers short-term and long term interest rates with the fed rate.

 After a severe recession a liquidity trap may occur. As a result of this businesses and people at large are afraid to spend no matter how much credit is available. Instead they will hoard their cash since the market is very flooded.

Implications of liquidity trap on monetary policy.

1)     Interest rates have to be low. For instance the fed funds rate is at zero. When this happens, no one wants to own bonds simply because when a bond bought today for instance that pays low rates won't be as valuable after interest rates rise. The low-rate bond will not be valued so much.

2)     Businesses don't invest fully. This is because instead of buying new capital equipment they make do with the old. They take advantage of low interest rates and borrow money, but they use it to buy back shares and artificially boost stock prices.

3)     Companies don't hire new employees as they should this will make the wages to remain constant.

4)     Consumer prices will remain low. Since there is no inflation, people will not buy goods before prices go up. 

5)     Banks don't increase lending of loans.