Question

The unconventional monetary policy undertaken during the financial crisis and the great recession in 2008-09 and compare the current Zero bound lower (ZBL) interest rate. What is the so-called “liquidity trap” and what are the remedies?

Answer 1

The great recession and the financial crisis of 2008-09 forced the central bank of the United States, the Federal Reserve, to take necessary actions to bring down stability and economic growth in the economy.

Conventional monetary policy of the central banks is well known. The central banks use interest rates as their primary tool to achieve their goals of either monetary expansion or contraction according to the need of the economy of either eonomic growth or of bringing down inflation.

However, during the great recession, even when the interest rates had fallen to zero, failed to revive the economy. Thus, the Fed was forced to take some unconventional monetary policy actions, such as negative interest rates, quantitative easing ( asset purchases ), forward guidance etc. The Fed mainly used quantitative easing during the financial crisis to revive the economy.

Given the Covid-19's impact on the economy, the Central bank has again started the use of both conventional as well as unconventional tools to help the economy get back on track as soon as possible. The Fed has set the target for the Fed funds rate, the benchmark interest rate, to 0.25% to 0%, also called zero bound interest rate.

A liquidity trap is a situation when due to very low interest rates, people tend to avoid spending and hold cash by preferring full liquidity, rather than investing in earning very low returns on debt instruments such as bonds etc., thereby rendering monetary policy ineffective. A liquidity trap generally takes place after a severe recession. People in general and businesses are afraid to spend no matter how much credit is available.

Some of the remedies after a liquidity trap is huge increase in government spending which leads to creation of new jobs, and increase in economic activities leading to confidence in the consumers of expected revival in aggregate demand.

A short term increase in interest rates may as well spur investment by businesses and people. Even financial institutions get encouraged and may start investing and lending more aggressively.