What is liquidity trap? Discuss its implications on the economy.

Monetary policy can kickstart the economy by decreasing the interest rates so that the borrowing becomes cheaper and the economy grows with the help of investment, but this process is halted in case of a liquidity trap.

Normally, with the increase in interest rates, the money demand in the economy increases, and income rises. But in a liquidity trap, any increase in money supply by the central bank fails to increase the money demand, i.e the interest rates have fallen to such low levels that people are not willing to invest and absorb all the money supplied. So it is not beneficial to reduce the interest rates further. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, recession, or war.

Implications:

  • Reduces the scope of institutional intervention.
  • The sustained slowdown reduces the macro-economic stability.
  • Markets do not respond to interventions suggesting that deep structural issues need to be addressed.
  • It may push the economy into recession, wages remain stagnant, and consumer prices remain low.

During covid, the central banks across the world have used their expansionary monetary policy in response to the crisis and dropped interest rates to negligible levels. At that time economy was in a liquidity trap.

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