Question

Give an Analysis Liquidity Trap of the 2008-09 recession...

Answer 1

An economy is said to be in a liquidity trap when the monetary authority cannot achieve lower nominal interest rates in order to stimulate output. Such a situation can arise when the nominal interest rate has reached its zero lower bound below which nobody would willing to lend.

Conditions of a Liquidity Trap:There are two main characteristics to a liquidity trap: an extremely low interest rate and the ineffectiveness of open-market operations. Other symptoms include a recession and slow recovery.

It is important to understand the U.S financial crisis in order to understand how the possibility of a liquidity trap in the U.S came out.

* The roots of the crisis go back to the early 2000s. The Fed lowered the interest rates in the aftermath of the dot-com bubble and kept them low even after recovery:this stimulated economic growth by creating a lot of credit that increased borrowings. It worked in the housing market but investors were not benefitting from the low interest rates so they began to take more risks to get higher yields. Slowly this market weakens in 2005 and 2007. As the crisis deepened in 2008,banks and other lending institutions became increasingly wary of lending, investors were less willing to take risk, and people were unwilling to borrow.

* The Fed engaged expansionary policy in response to the recession. In 2008,it has lowered the interest rate several times but economic situation then became so bad that Fed decided to lower the interest rate close to zero, despite fears that it could create the same speculative bubble that happened the last time those rates were low.

* After the Fed began lowering interest rates in 2007,real GDP continued to fall through 2009.from 2007 to 2008,real GDP fell 0.3% and fell 3.5% from 2008 to 2009. The Fed is increasingly lowering interest rates closer and closer to zero but this has not had much of an impact on the economy. It has not stimulated growth much, at least not in the short run, indicating the ineffectiveness of open-market operations. The low interest rates, decreased effectiveness of open-market operations.

* In 2008,banks lost significant sums of money in buying sub-prime debt which defaulted. Then they became reluctant to lend.

To summarise, I have analysed the Liquidity Trap of the 2008-09 recession, i.e. The prevalence of low interest rates and the ineffectiveness of open-market operations as indicated by continued stagnation.

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