Question

1. In the traditional liquidity trap, what happens when the government engeages in open market operation?

2. Now suppose money(reserves) are considered less liquid than bonds, what happens?

Answer 1

1. In the traditional liquidity trap, what happens when the government engeages in open market operation?

Definition: Liquidity trap is a situation when expansionary monetary policy (increase in money supply) does not increase the interest rate, income and hence does not stimulate economic growth.

Description: Liquidity trap is the extreme effect of monetary policy. It is a situation in which the general public is prepared to hold on to whatever amount of money 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 interest rate.

There is a liquidity trap at short term zero percent interest rate. When interest rate is zero, public would not want to hold any bond, since money, which also pays zero percent interest, has the advantage of being usable in transactions.

Hence, if the interest is zero, an increase in quantity of money cannot not induce anyone to buy bonds and thereby reduce the interest on bonds below zero.

2. Now suppose money(reserves) are considered less liquid than bonds, what happens?

What is a 'Bank Reserve'

A bank reserve is the currency deposit which is not lent out to the bank's clients. A small fraction of the total deposits is held internally by the bank in cash vaults or deposited with the central bank. Minimum reserve requirements are established by central banks in order to ensure that the financial institutions will be able to provide clients with cash upon request.

BREAKING DOWN 'Bank Reserve'

Bank reserves are typically held by financial institutions to avoid bank runs and have sufficient cash on hand, should an unexpected and large withdrawal request come up. Bank reserves are divided into required reserves and excess reserves. Because of the banking industry's importance to the economy, national authorities regulate banks by obligating them to hold a certain amount of required reserves with central banks.

Excess reserves represent any vault cash that banks hold that is in excess of the required reserves amount. Banks typically have low incentive to maintain excess reserves because cash earns the rate of return of zero and can lose value over time due to inflation. Thus, under normal circumstances, banks minimize their excess reserves and lend out money to clients rather than holding cash in their vaults. Bank reserves decrease during periods of economic expansion and increase during recessions.

Required Reserves

According to the Federal Reserve Board's regulation, the required reserves represent the amount of funds a bank must hold in its cash vault or deposit with the central bank against certain liabilities. The reserve ratio determines the required reserve, and it varies by the amount deposited in net transaction accounts, which include demand deposits, automatic transfer accounts and share draft accounts. Net transactions are calculated as the total amount in transaction accounts minus funds due from other banks and less cash in the process of collection.

The required reserve ratio can be used by national authorities as a tool to implement monetary policies. Through this ratio, a central bank can influence the amount of funds available for borrowing. Beginning in October 2008, the Federal Reserve began paying interest to the banks for required and excess reserves as a way to infuse more liquidity into the U.S. monetary circulation. The rates on required and excess reserves are determined separately and depend on the targeted federal funds rate.

Excess Reserves

Banks typically keep excess reserves at a minimum, because these reserves do not earn any interest. However, because the Federal Reserve engaged in an accommodating monetary policy after December 2008, the interest rate at which banks could originate their loans decreased dramatically. The banks took funds injected by the Federal Reserve and kept them as excess reserves, which are earning an essentially risk-free interest rate subsequent to the policy change in 2008. For this reason, the amount of excess reserves spiked after 2008, despite an unchanged required reserve ratio.