Question

This is the liquidity effect question you’ve all been waiting for. You must use graphs in parts (a) and (b) to receive full credit.

(a) Assume that prices are perfectly flexible in a closed economy. Demonstrate the impact of an increase in the money supply on the equilibrium expected real rate of interest, the price level, private saving, private investment, and real balances using the credit and money markets.

(b) Assume that the price level is fixed in the short run. Describe the impact of an increase in the money supply on the expected real rate of interest.

(c) Describe the liquidity effect and the key assumptions that must be made for the liquidity effect to be observed.

(d) Assume there is a liquidity effect. Describe the impact on velocity. Is there a liquidity trap? Explain.

Answer 1

A) The impact of an increase in the money supply on the equilibrium expected real rate of interest, the price level, private saving, private investment, and real balances using the credit and money markets.

Who controls the quantity of money that circulates in an economy, the money supply. Central banks determine the money supply. ♦ In the US, the central bank is the Federal Reserve System. ♦ The Federal Reserve System directly regulates the quantity of currency in circulation, also as banking industry reserves. ♦ It indirectly controls the quantity of checking deposits issued by private banks.

By increasing the amount of money in the economy, the central bank encourages private consumption. Increasing the cash supply also decreases the rate of interest, which inspires lending and investment. The increase in consumption and investment results in a better aggregate demand. An increase in supply, all other things unchanged, will cause the equilibrium price to fall; quantity demanded will increase. A decrease in supply will cause the equilibrium price to rise; quantity demanded will decrease. An increase within the funds means extra money is out there for borrowing within the economy. ... In the short run, higher rates of consumption and lending and borrowing can be correlated with an increase in the total output of an economy and spending and, presumably, a country's GDP.

Money supply important

Because money is employed in virtually all economic transactions, it's a strong effect on economic activity. An increase within the supply of cash works both through lowering interest rates, which spurs investment, and thru putting extra money within the hands of consumers, making them feel wealthier, and thus stimulating spending. Business firms respond to increased sales by ordering more raw materials and increasing production. The spread of commercial activity increases the demand for labor and raises the demand for capital goods. In a buoyant economy, stock exchange prices rise and firms issue equity and debt. If the cash supply continues to expand, prices begin to rise, especially if output growth reaches capacity limits. As the public begins to expect inflation, lenders enforce higher interest rates to offset an expected decline in purchasing power over the lifetime of their loans.

Ways to increase the money supply

1. Print more money – usually, this is done by the Central Bank, though in some countries governments can dictate the money supply. For example in Zimbabwe 2000s – the govt printed extra money to pay wages.
2. Reducing interest rates. Lower interest rates reduce the cost of borrowing. This makes investment relatively more profitable, then encourages economic activity. Consumers also will see cheaper mortgage payments resulting in higher income . Read more – effect of cutting interest rates
3. Quantitative easing The Central Bank can also electronically create money. Under a policy of quantitative easing, they plan to increase their bank reserves ‘effectively create money out of thin air’. The created money are often wont to buy assets; the thought is to extend cash reserves of banks.
4. Reduce the reserve ratio for lending. The reserve ratio is the percentage of deposits that bank keeps in cash reserves. If the reserve ratio is reduced, then the bank will lend more and thanks to the cash multiplier, we'll see an increase in bank lending. Central Banks can set a minimum reserve ratio. Reducing this ratio
5. Increase confidence in the banking system. If banks believe within the economic system , then they're going to be more willing to lend. In the credit crisis, it had been necessary for the govt to ensure bank deposits and nationalise struggling banks
6. Central Bank buying government securities. The Central Bank pays investors holding bonds. If the financial institution buy Government securities (or corporate bonds) people that were holding the bonds have extra money to spend. Banks see illiquid assets become liquid. Therefore, in certain circumstances, this can lead to an increase in the money supply. However, it depends on whether the bond purchases are sterilised or ‘unsterilised’. Unsterilised means they create money to buy bonds.
7. Expansionary fiscal policy. In a recession, there's often a ‘paradox of thrift’ business and consumers want to extend savings – and this results in a fall in spending and investment. If the government borrows from the private sector and spends on public work investment schemes then this will start a multiplier effect where households gain wages to spend and encourage private sector investment.

In recent decades the cash supply has been increasing because:
• Reduction in reserve ratio by banks – seeking greater profitability
• Creation of new types of liquid assets which make it easier for banks to lend
• Increased velocity of circulation. – The number of times cash changes
• Interest rates: money pays little or no interest, so the interest rate is the opportunity cost of holding money instead of other assets, like bonds, which have a higher expected return/interest rate. a better rate of interest means a better cost of holding money → lower money demand Prices: the costs of products and services bought in transactions will influence the willingness to carry money to conduct those transactions.A higher price level means a greater need for liquidity to buy the same amount of goods and services → higher money demand hands.
Investment spending is a crucial category of real GDP. Not only is it always the foremost volatile a part of real GDP, but investment spending on physical capital is additionally a crucial contributor to economic process . So, if a firm wants to create a replacement factory, where does it get the funds to create it? Usually, firms borrow that money.
The marketplace for loanable funds describes how that borrowing happens. The supply of loanable funds is predicated on savings. The demand for loanable funds is predicated on borrowing. The interaction between the availability of savings and therefore the demand for loans determines the important rate of interest and the way much is loaned out.

B) The price level is fixed in the short run

It’s fixed in place and, if it’s moving, it’s doing so really slowly! When things don’t move or adjust quickly, economists will often ask them as “sticky.” as an example , if market prices or wages don’t adjust quickly to changes within the economy, they are called sticky prices. And when faced with things like sticky wages and costs , an economy won't produce its financial condition output.
The short-run aggregate supply curve (SRAS) lets us capture how all of the firms in an economy answer price stickiness. When prices are sticky, the SRAS curve will slope upward. The SRAS curve shows that a better price index results in more output.

There are two important things to notice about SRAS. For one, it represents a short-run relationship between price level and output supplied. Aggregate supply slopes up within the short-run because a minimum of one price is inflexible. Second, SRAS also tells us there's a short-run tradeoff between inflation and unemployment. Because higher inflation results in more output, higher inflation is additionally related to lower unemployment within the short run.

By the term fixed price, we mean that price remains constant. They do not change as per demand and provide conditions within the short run. The reason behind this is that there are always chances that aggregate demand and supply do not equalize in an economy. Prices take time to respond to these conditions.
A single firm might not be a really" during a position to influence prices because it could be contributing a very small share to the entire market output. Therefore, firms might become individual price takers in the short run (like the case of perfect competition). For these reasons, within the short-run, prices remain fixed. Prices change in the long-run.
impact of an increase in the money supply on the expected real rate of interest.
All else being equal, a bigger funds lowers market interest rates, making it less costly for consumers to borrow. Conversely, smaller money supplies tend to boost market interest rates, making it pricier for consumers to require out a loan. The current level of liquid money (supply) coordinates with the entire demand for liquid money (demand) to assist determine interest rates. More Money Available, Lower Interest Rates
In a free enterprise , all prices, even prices for present money, are coordinated by supply and demand. Some individuals have a greater demand for present money than their current reserves allow; most homebuyers don't have $300,000 lying around, for example. To get more present money, these individuals enter the credit market and borrow from those that have an more than present money (savers). Interest rates determine the value of the borrowed present money.

C) Liquidity Effect

When the Fed pursues a decent monetary policy, it takes money out of the system by selling Treasury securities and raising the reserve requirement at banks. This raises interest rates because the demand for credit is so high that lenders price their loans higher to require advantage of the demand. Tight money and high interest rates tend to slow economic activity and may cause a recession. During periods of financial condition companies, terminate employees and consumers crop on their spending. House prices also decline as fewer people are ready to afford the boom time prices. So, low liquidity has the other effect on the economy from high liquidity.

Liquidity effect, in economics, refers broadly to how increases or decreases within the availability of cash influence interest rates and consumer spending, also as investments and price stability. The Federal Reserve, the main body that controls the availability of money in the United States, employs mechanisms such as changes in the amount of money banks keep in reserve and the sale or purchase of Treasury securities to create liquidity effect.

Liquidity preference theory may be a model that means that an investor should demand a better rate of interest or premium on securities with long-term maturities that carry greater risk because, all other factors being equal, investors prefer cash or other highly liquid holdings.
According to this theory, which was developed by John Maynard Keynes in support of his idea that the demand for liquidity holds speculative power, investments that are more liquid are easier to cash in for full value. Cash is usually accepted because the most liquid asset. According to the liquidity preference theory, interest rates on short-term securities are lower because investors aren't sacrificing liquidity for greater time frames than medium or longer-term securities.

The term “liquidity” is widely used in the literature, though its understanding varies significantly. The goal of the first section of the Chapter is, thus, to provide an unambiguous definition, which could be referred to throughout the analysis. Firstly, existing notions of liquidity are reviewed and classified into two main approaches: one focusing on the characteristics of assets (asset liquidity) and the other one regarding the subject from the market perspective (market liquidity). In the second step, the concept of liquidity risk is introduced and integrated into these approaches; a two-dimensional notion of liquidity results.

In particular, the main characteristics of investments and investment environments, which may have a significant impact on different aspects of liquidity, are discussed.

The following, third section adds a practical dimension to the discussion. A review of assets with respect to which liquidity problems are especially severe is offered and their characteristics are analyzed. The identification of illiquid assets is also necessary to determine the scope of application of the methods developed later. Finally, the fourth section deals with the economic relevance of liquidity. Its role in the economy is discussed concentrating especially on individual investment decisions.

Liquidity: a requirement for greater liquidity occurs when either the worth of transactions increases or the number of products normally bought in transactions increases.

(d) Liquidity Trap

A liquidity trap may be a contradictory economic situation during which interest rates are very low and savings rates are high, rendering monetary policy ineffective. First described by economist John Maynard Keynes, during a liquidity trap, consumers prefer to avoid bonds and keep their funds in cash savings due to the prevailing belief that interest rates could soon rise (which would push bond prices down). Because bonds have an inverse relationship to interest rates, many consumers don't want to carry an asset with a price that's expected to say no . At an equivalent time, financial institution efforts to spur economic activity are hampered as they're unable to lower interest rates further to incentivize investors and consumers.

• A liquidity trap is when monetary policy becomes ineffective due to very low interest rates combined with consumers who prefer to save rather than invest in higher-yielding bonds or other investments.
• While a liquidity trap is a function of economic conditions, it is also psychological since consumers are making a choice to hoard cash instead of choosing higher-paying investments because of a negative economic view.
• A liquidity trap isn't limited to bonds. It also affects other areas of the economy, as consumers are spending less on products which suggests businesses are less likely to rent .
• Some ways to get out of a liquidity trap include raising interest rates, hoping the situation will regulate itself as prices fall to attractive levels, or increased government spending.
• One marker of a liquidity trap is low interest rates. Low interest rates can affect bondholder behavior, along side other concerns regarding the present financial state of the state , leading to the selling of bonds during a way that is harmful to the economy.

Further, additions made to the cash supply fail to end in price index changes, as consumer behavior leans toward saving funds in low-risk ways. Since a rise in funds means extra money is within the economy, it's reasonable that a number of that cash should flow toward the higher-yield assets like bonds. But during a liquidity trap it doesn't, it just gets stashed away in cash accounts as savings.
• Low interest rates alone do not define a liquidity trap. For things to qualify, there has got to be a scarcity of bondholders wishing to stay their bonds and a limited supply of investors looking to get them. Instead, the investors are prioritizing strict cash savings over bond purchasing. If investors are still curious about holding or purchasing bonds sometimes when interest rates are low, even approaching zero percent, things doesn't qualify as a liquidity trap.

Description:

Liquidity trap is that the extreme effect of monetary policy. It is a situation during which the overall public is ready to carry on to whatever amount of cash is supplied, at a given rate of interest. They do so because of the fear of adverse events like deflation, war.
In that case, a monetary policy carried out through open market operations has no effect on either the interest rate, or the level of income. In a liquidity trap, the monetary policy is powerless to affect the rate of interest .
There is a liquidity trap at short term zero percent rate of interest . When rate of interest is zero, public wouldn't want to carry any bond, since money, which also pays zero percent interest, has the advantage of being usable in transactions.
Hence, if the interest is zero, a rise in quantity of cash cannot not induce anyone to shop for bonds and thereby reduce the interest on bonds below zero.

The impact on velocity, Is there a liquidity trap:

A liquidity trap often occurs after a severe recession. Families and businesses are afraid to spend regardless of what proportion credit is out there . It's like a flooded car engine. You've released such a lot gas into the engine that it crowds out the oxygen. Pumping the gas pedal doesn't help.
That's what happens in a liquidity trap. The Fed's gas is credit and therefore the pedal is lower interest rates. When the Fed pushes the accelerator , it doesn't rev up the economic engine. Instead, businesses and families hoard their cash. They don't have the confidence to spend it, so they do nothing. The economic engine is flooded.

Low-Interest Rates
For a liquidity trap to occur, interest rates must near or at zero. If it's been there for a while, people believe that interest rates have nowhere to go but up. When that happens, no one wants to own bonds. A bond bought today that pays low rates won't be as valuable after interest rates rise. Everyone will want the bonds issued then because it pays a higher return. The low-rate bond will be worth less in comparison.

Prices Remain Low
Consumer prices remain low. Typically, when the central bank adds to the money supply, it creates inflation. During normal times, for each 1% increase in the growth of money, inflation increases by 0.54%.1
In a liquidity trap, it's more likely there'll be deflation or falling prices. People postpone buying things because they believe prices are going to be lower within the future.

Businesses Don't Spend the Extra Cash
Businesses don't take advantage of low-interest rates to invest in expansion. Instead, they use it to buy back shares and artificially boost stock prices. They don't use it to shop for new capital equipment, they create do with the old. They might also purchase new companies in mergers and acquisitions or leveraged buy-outs. These activities boost the stock exchange but not the economy.

Wage Remain Stagnant
Companies are also reluctant to use the extra funds to hire new workers. As a result, wages remain stagnant. Without rising incomes, families only buy what they need and save the rest. This further contributes to the lack of demand.
Lower Interest Rates Don't Translate to Increased Lending
Banks are supposed to take the extra money the Fed pumps into the economy and lend it out in mortgages, small business loans, and credit cards. During a recession, people aren't confident, so they won't borrow. Banks use the additional cash to write down down debt or increase their capital to guard against future debt . They might raise their lending requirements, as well.

Five things can get the economy out of a liquidity trap by stimulating demand.

Raise Interest Rates
First, the Fed raises interest rates. An increase in short-term rates encourages people to invest and save their cash, instead of hoarding it. Higher long-term rates encourage banks to lend since they'll get a better return. That increases the velocity of money.

Price Fall Enough
The economy could get going again once prices fall to such a coffee point that folks just can't resist shopping. It can happen with commodity or assets like stocks. Investors start buying again because they know they will hold onto the asset long enough to outlast the slump. The future reward has become greater than the danger.

Expansionary Fiscal Policy
The government can end a liquidity trap through expansionary economic policy . That's either a tax cut or an increase in government spending, or both. That creates confidence that the nation's leaders will support economic growth. It also directly creates jobs, reducing unemployment and the need for hoarding.

Financial Innovation
Fourth, financial innovation creates an entirely new market. That makes financial assets, like stocks, bonds, or derivatives, more attractive than holding cash.

Global Rebalancing
If some countries are experiencing a liquidity trap, et al. aren't , then governments could end the trap by coordinating global rebalancing. That's when countries that have too much of one thing trade to those that have too little.
For example, China and therefore the eurozone have an excessive amount of cash engaged in savings. That's a result of consumer spending in the United States on Chinese exports. China must invest more in the United States to get that money back into circulation.

A) The impact of an increase in the money supply on the equilibrium expected real rate of interest, the price level, private saving, private investment, and real balances using the credit and money markets.

Who controls the quantity of money that circulates in an economy, the money supply. Central banks determine the money supply. ♦ In the US, the central bank is the Federal Reserve System. ♦ The Federal Reserve System directly regulates the quantity of currency in circulation, also as banking industry reserves. ♦ It indirectly controls the quantity of checking deposits issued by private banks.

By increasing the amount of money in the economy, the central bank encourages private consumption. Increasing the cash supply also decreases the rate of interest, which inspires lending and investment. The increase in consumption and investment results in a better aggregate demand. An increase in supply, all other things unchanged, will cause the equilibrium price to fall; quantity demanded will increase. A decrease in supply will cause the equilibrium price to rise; quantity demanded will decrease. An increase within the funds means extra money is out there for borrowing within the economy. ... In the short run, higher rates of consumption and lending and borrowing can be correlated with an increase in the total output of an economy and spending and, presumably, a country's GDP.

Money supply important

Because money is employed in virtually all economic transactions, it's a strong effect on economic activity. An increase within the supply of cash works both through lowering interest rates, which spurs investment, and thru putting extra money within the hands of consumers, making them feel wealthier, and thus stimulating spending. Business firms respond to increased sales by ordering more raw materials and increasing production. The spread of commercial activity increases the demand for labor and raises the demand for capital goods. In a buoyant economy, stock exchange prices rise and firms issue equity and debt. If the cash supply continues to expand, prices begin to rise, especially if output growth reaches capacity limits. As the public begins to expect inflation, lenders enforce higher interest rates to offset an expected decline in purchasing power over the lifetime of their loans.

Ways to increase the money supply

1. Print more money – usually, this is done by the Central Bank, though in some countries governments can dictate the money supply. For example in Zimbabwe 2000s – the govt printed extra money to pay wages.
2. Reducing interest rates. Lower interest rates reduce the cost of borrowing. This makes investment relatively more profitable, then encourages economic activity. Consumers also will see cheaper mortgage payments resulting in higher income . Read more – effect of cutting interest rates
3. Quantitative easing The Central Bank can also electronically create money. Under a policy of quantitative easing, they plan to increase their bank reserves ‘effectively create money out of thin air’. The created money are often wont to buy assets; the thought is to extend cash reserves of banks.
4. Reduce the reserve ratio for lending. The reserve ratio is the percentage of deposits that bank keeps in cash reserves. If the reserve ratio is reduced, then the bank will lend more and thanks to the cash multiplier, we'll see an increase in bank lending. Central Banks can set a minimum reserve ratio. Reducing this ratio
5. Increase confidence in the banking system. If banks believe within the economic system , then they're going to be more willing to lend. In the credit crisis, it had been necessary for the govt to ensure bank deposits and nationalise struggling banks
6. Central Bank buying government securities. The Central Bank pays investors holding bonds. If the financial institution buy Government securities (or corporate bonds) people that were holding the bonds have extra money to spend. Banks see illiquid assets become liquid. Therefore, in certain circumstances, this can lead to an increase in the money supply. However, it depends on whether the bond purchases are sterilised or ‘unsterilised’. Unsterilised means they create money to buy bonds.
7. Expansionary fiscal policy. In a recession, there's often a ‘paradox of thrift’ business and consumers want to extend savings – and this results in a fall in spending and investment. If the government borrows from the private sector and spends on public work investment schemes then this will start a multiplier effect where households gain wages to spend and encourage private sector investment.

In recent decades the cash supply has been increasing because:
• Reduction in reserve ratio by banks – seeking greater profitability
• Creation of new types of liquid assets which make it easier for banks to lend
• Increased velocity of circulation. – The number of times cash changes
• Interest rates: money pays little or no interest, so the interest rate is the opportunity cost of holding money instead of other assets, like bonds, which have a higher expected return/interest rate. a better rate of interest means a better cost of holding money → lower money demand Prices: the costs of products and services bought in transactions will influence the willingness to carry money to conduct those transactions.A higher price level means a greater need for liquidity to buy the same amount of goods and services → higher money demand hands.
Investment spending is a crucial category of real GDP. Not only is it always the foremost volatile a part of real GDP, but investment spending on physical capital is additionally a crucial contributor to economic process . So, if a firm wants to create a replacement factory, where does it get the funds to create it? Usually, firms borrow that money.
The marketplace for loanable funds describes how that borrowing happens. The supply of loanable funds is predicated on savings. The demand for loanable funds is predicated on borrowing. The interaction between the availability of savings and therefore the demand for loans determines the important rate of interest and the way much is loaned out.

B) The price level is fixed in the short run

It’s fixed in place and, if it’s moving, it’s doing so really slowly! When things don’t move or adjust quickly, economists will often ask them as “sticky.” as an example , if market prices or wages don’t adjust quickly to changes within the economy, they are called sticky prices. And when faced with things like sticky wages and costs , an economy won't produce its financial condition output.
The short-run aggregate supply curve (SRAS) lets us capture how all of the firms in an economy answer price stickiness. When prices are sticky, the SRAS curve will slope upward. The SRAS curve shows that a better price index results in more output.

There are two important things to notice about SRAS. For one, it represents a short-run relationship between price level and output supplied. Aggregate supply slopes up within the short-run because a minimum of one price is inflexible. Second, SRAS also tells us there's a short-run tradeoff between inflation and unemployment. Because higher inflation results in more output, higher inflation is additionally related to lower unemployment within the short run.

By the term fixed price, we mean that price remains constant. They do not change as per demand and provide conditions within the short run. The reason behind this is that there are always chances that aggregate demand and supply do not equalize in an economy. Prices take time to respond to these conditions.
A single firm might not be a really" during a position to influence prices because it could be contributing a very small share to the entire market output. Therefore, firms might become individual price takers in the short run (like the case of perfect competition). For these reasons, within the short-run, prices remain fixed. Prices change in the long-run.

impact of an increase in the money supply on the expected real rate of interest.
All else being equal, a bigger funds lowers market interest rates, making it less costly for consumers to borrow. Conversely, smaller money supplies tend to boost market interest rates, making it pricier for consumers to require out a loan. The current level of liquid money (supply) coordinates with the entire demand for liquid money (demand) to assist determine interest rates. More Money Available, Lower Interest Rates.

In a free enterprise , all prices, even prices for present money, are coordinated by supply and demand. Some individuals have a greater demand for present money than their current reserves allow; most homebuyers don't have $300,000 lying around, for example. To get more present money, these individuals enter the credit market and borrow from those that have an more than present money (savers). Interest rates determine the value of the borrowed present money.

C) Liquidity Effect

When the Fed pursues a decent monetary policy, it takes money out of the system by selling Treasury securities and raising the reserve requirement at banks. This raises interest rates because the demand for credit is so high that lenders price their loans higher to require advantage of the demand. Tight money and high interest rates tend to slow economic activity and may cause a recession. During periods of financial condition companies, terminate employees and consumers crop on their spending. House prices also decline as fewer people are ready to afford the boom time prices. So, low liquidity has the other effect on the economy from high liquidity.

Liquidity effect, in economics, refers broadly to how increases or decreases within the availability of cash influence interest rates and consumer spending, also as investments and price stability. The Federal Reserve, the main body that controls the availability of money in the United States, employs mechanisms such as changes in the amount of money banks keep in reserve and the sale or purchase of Treasury securities to create liquidity effect.

Liquidity preference theory may be a model that means that an investor should demand a better rate of interest or premium on securities with long-term maturities that carry greater risk because, all other factors being equal, investors prefer cash or other highly liquid holdings.
According to this theory, which was developed by John Maynard Keynes in support of his idea that the demand for liquidity holds speculative power, investments that are more liquid are easier to cash in for full value. Cash is usually accepted because the most liquid asset. According to the liquidity preference theory, interest rates on short-term securities are lower because investors aren't sacrificing liquidity for greater time frames than medium or longer-term securities.

The term “liquidity” is widely used in the literature, though its understanding varies significantly. The goal of the first section of the Chapter is, thus, to provide an unambiguous definition, which could be referred to throughout the analysis. Firstly, existing notions of liquidity are reviewed and classified into two main approaches: one focusing on the characteristics of assets (asset liquidity) and the other one regarding the subject from the market perspective (market liquidity). In the second step, the concept of liquidity risk is introduced and integrated into these approaches; a two-dimensional notion of liquidity results.

In particular, the main characteristics of investments and investment environments, which may have a significant impact on different aspects of liquidity, are discussed.

The following, third section adds a practical dimension to the discussion. A review of assets with respect to which liquidity problems are especially severe is offered and their characteristics are analyzed. The identification of illiquid assets is also necessary to determine the scope of application of the methods developed later. Finally, the fourth section deals with the economic relevance of liquidity. Its role in the economy is discussed concentrating especially on individual investment decisions.

Liquidity: a requirement for greater liquidity occurs when either the worth of transactions increases or the number of products normally bought in transactions increases.

(d) Liquidity Trap

A liquidity trap may be a contradictory economic situation during which interest rates are very low and savings rates are high, rendering monetary policy ineffective. First described by economist John Maynard Keynes, during a liquidity trap, consumers prefer to avoid bonds and keep their funds in cash savings due to the prevailing belief that interest rates could soon rise (which would push bond prices down). Because bonds have an inverse relationship to interest rates, many consumers don't want to carry an asset with a price that's expected to say no . At an equivalent time, financial institution efforts to spur economic activity are hampered as they're unable to lower interest rates further to incentivize investors and consumers.

• A liquidity trap is when monetary policy becomes ineffective due to very low interest rates combined with consumers who prefer to save rather than invest in higher-yielding bonds or other investments.
• While a liquidity trap is a function of economic conditions, it is also psychological since consumers are making a choice to hoard cash instead of choosing higher-paying investments because of a negative economic view.
• A liquidity trap isn't limited to bonds. It also affects other areas of the economy, as consumers are spending less on products which suggests businesses are less likely to rent .
• Some ways to get out of a liquidity trap include raising interest rates, hoping the situation will regulate itself as prices fall to attractive levels, or increased government spending.
• One marker of a liquidity trap is low interest rates. Low interest rates can affect bondholder behavior, along side other concerns regarding the present financial state of the state , leading to the selling of bonds during a way that is harmful to the economy.

Further, additions made to the cash supply fail to end in price index changes, as consumer behavior leans toward saving funds in low-risk ways. Since a rise in funds means extra money is within the economy, it's reasonable that a number of that cash should flow toward the higher-yield assets like bonds. But during a liquidity trap it doesn't, it just gets stashed away in cash accounts as savings.
• Low interest rates alone do not define a liquidity trap. For things to qualify, there has got to be a scarcity of bondholders wishing to stay their bonds and a limited supply of investors looking to get them. Instead, the investors are prioritizing strict cash savings over bond purchasing. If investors are still curious about holding or purchasing bonds sometimes when interest rates are low, even approaching zero percent, things doesn't qualify as a liquidity trap.

Description:

Liquidity trap is that the extreme effect of monetary policy. It is a situation during which the overall public is ready to carry on to whatever amount of cash is supplied, at a given rate of interest. They do so because of the fear of adverse events like deflation, war.
In that case, a monetary policy carried out through open market operations has no effect on either the interest rate, or the level of income. In a liquidity trap, the monetary policy is powerless to affect the rate of interest .
There is a liquidity trap at short term zero percent rate of interest . When rate of interest is zero, public wouldn't want to carry any bond, since money, which also pays zero percent interest, has the advantage of being usable in transactions.
Hence, if the interest is zero, a rise in quantity of cash cannot not induce anyone to shop for bonds and thereby reduce the interest on bonds below zero.

The impact on velocity, Is there a liquidity trap:

A liquidity trap often occurs after a severe recession. Families and businesses are afraid to spend regardless of what proportion credit is out there . It's like a flooded car engine. You've released such a lot gas into the engine that it crowds out the oxygen. Pumping the gas pedal doesn't help.
That's what happens in a liquidity trap. The Fed's gas is credit and therefore the pedal is lower interest rates. When the Fed pushes the accelerator , it doesn't rev up the economic engine. Instead, businesses and families hoard their cash. They don't have the confidence to spend it, so they do nothing. The economic engine is flooded.

Low-Interest Rates
For a liquidity trap to occur, interest rates must near or at zero. If it's been there for a while, people believe that interest rates have nowhere to go but up. When that happens, no one wants to own bonds. A bond bought today that pays low rates won't be as valuable after interest rates rise. Everyone will want the bonds issued then because it pays a higher return. The low-rate bond will be worth less in comparison.

Prices Remain Low
Consumer prices remain low. Typically, when the central bank adds to the money supply, it creates inflation. During normal times, for each 1% increase in the growth of money, inflation increases by 0.54%.1
In a liquidity trap, it's more likely there'll be deflation or falling prices. People postpone buying things because they believe prices are going to be lower within the future.

Businesses Don't Spend the Extra Cash
Businesses don't take advantage of low-interest rates to invest in expansion. Instead, they use it to buy back shares and artificially boost stock prices. They don't use it to shop for new capital equipment, they create do with the old. They might also purchase new companies in mergers and acquisitions or leveraged buy-outs. These activities boost the stock exchange but not the economy.

Wage Remain Stagnant
Companies are also reluctant to use the extra funds to hire new workers. As a result, wages remain stagnant. Without rising incomes, families only buy what they need and save the rest. This further contributes to the lack of demand.
Lower Interest Rates Don't Translate to Increased Lending
Banks are supposed to take the extra money the Fed pumps into the economy and lend it out in mortgages, small business loans, and credit cards. During a recession, people aren't confident, so they won't borrow. Banks use the additional cash to write down down debt or increase their capital to guard against future debt . They might raise their lending requirements, as well.

Five things can get the economy out of a liquidity trap by stimulating demand.

Raise Interest Rates
First, the Fed raises interest rates. An increase in short-term rates encourages people to invest and save their cash, instead of hoarding it. Higher long-term rates encourage banks to lend since they'll get a better return. That increases the velocity of money.

Price Fall Enough
The economy could get going again once prices fall to such a coffee point that folks just can't resist shopping. It can happen with commodity or assets like stocks. Investors start buying again because they know they will hold onto the asset long enough to outlast the slump. The future reward has become greater than the danger.

Expansionary Fiscal Policy
The government can end a liquidity trap through expansionary economic policy . That's either a tax cut or an increase in government spending, or both. That creates confidence that the nation's leaders will support economic growth. It also directly creates jobs, reducing unemployment and the need for hoarding.

Financial Innovation
Fourth, financial innovation creates an entirely new market. That makes financial assets, like stocks, bonds, or derivatives, more attractive than holding cash.

Global Rebalancing
If some countries are experiencing a liquidity trap, et al. aren't , then governments could end the trap by coordinating global rebalancing. That's when countries that have too much of one thing trade to those that have too little.
For example, China and therefore the eurozone have an excessive amount of cash engaged in savings. That's a result of consumer spending in the United States on Chinese exports. China must invest more in the United States to get that money back into circulation.