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What is a Liquidity Trap?

The term 'Liquidity Trap' is included in the Banking edition of the Financial Dictionary. Get your copy on Amazon in Kindle, Paperback or Audio edition. Choose your edition here...

A Liquidity Trap refers to an unusual situation where the going interest rates prove to be low and the savings rates turn out to be high. This lends to ineffective monetary policy. When such a trap occurs, consumers will eschew bonds and instead opt for savings. The reason is that the consensus opinion believes that the prevailing interest rates will be rising in the near future. With bonds and their inverse price relationship to interest rates, a great number of consumers will not take a chance on holding assets that have prices which many people believe will inevitably decline soon.

The problem for the regulators at the Federal Reserve is that they cannot stimulate the national economy through their normal boosting of the money supply in these cases. It would not have any impact on interest rates in truth, so consumers do not have to be made to keep additional cash at the ready. Instead, a part of this liquidity trap revolves around the consumers holding their funds in basic checking account deposits or savings accounts rather than investing them in competing investment choices. This means that the central bankers at the Fed attempting to boost the economy by injecting in additional funds is ineffective. It is in fact the consumer actions which make the much-touted monetary policies more or less ineffective since consumers fear a negative economic scenario in the near future.

When a liquidity trap exists, there will be signs warning about it all around. One of these concerns unusually low interest rates. As they impact the behavior of bond holders and others who are worried about the economic condition of the country, this leads to bonds selling off across the board. This gets to the point that it hurts the economy finally. Extra money injected into the overall money supply does not deliver the changes in price levels since the consumers will be aggressively saving their funds into high liquidity and low risk vehicles. Consumers simply cannot be spurred to select other investment options unless the interest rates change substantially enough to overcome their innate sense of fear and appeal to their greed instead.

It is not lower interest rates by themselves that equate to the Liquidity Trap. In order for the situation to be a true trap, there must also be many bondholders who wish to hold on to their bonds, as well as a limited supply of those investors who are willing to buy them. What you see rather than this in a trap is that the investors will prioritize keeping their cash in strictly savings accounts instead of buying bonds. When investors want to buy or hold bonds while interest rates remain low (or even nearing the limit at zero), the scenario is not actually considered to be a true Liquidity Trap.

A real issue surrounding such Liquidity Traps pertains to financial institutions such as banks. They will not be capable of locating any borrowers who qualify for loans at a given level. This becomes more severe since interest rates are nearing zero. It means that they do not have any extra incentives to bring in the well-qualified, lower risk candidates which they always prefer to loan money to. The diminished borrowing activity typically leads to less buying activity. It means that more expensive and generally financed homes and other purchases (such as cars) are not being acquired by the average consumer while the Liquidity Trap is still ongoing.

The term 'Liquidity Trap' is included in the Banking edition of the Financial Dictionary. Get your copy on Amazon in Kindle, Paperback or Audio edition. Choose your edition here.