Question

What is a Liquidity Trap? Suppose the policymakers want to boost an economy in the event of a liquidity trap. What policy would you recommend and why? Explain your answer using IS-LM diagram(s

Answer 1

Liquidity trap is a situation suggested by J M Keynes as a special circumstance where at a very low interest rate people may become indifferent between holding money (cash) and investing in bonds and other interest yielding financial instruments. The demand for money function consisting of speculative demand for money and transaction demand for money becomes flat or horizontal. Refer to Fig 1 where r is interest rate, M/P is the real money demand and m(y) represents the money demand functions. For given levels of output, y₁, y₂, and y₃, we have three different money demand functions. Since, transaction demand for money depicts a positive relationship between output and money demand, higher the income, higher is the money demand. However, the money demand functions tend to converge at very high and low levels of interest rates. At low interest rates, when the money demand function is flat, then it is a situation of liquidity trap.

If the demand for money function is horizontal, then the LM curve will also become horizontal at that level of interest. LM curve is derived as the locus of all combinations of r and y along which the money market is in equilibrium. Refer to Fig 2. Understandably if the l(r) function representing speculative demand for money becomes flat and non-responsive to interest rates, then LM curve will also become flat. k(y) refers to the transaction demand for money. The IS curve will retain its usual shape. In the event of a liquidity trap like situation, monetary policy becomes completely ineffective in impacting the output and interest as with change in money supply the LM curve doesn’t shift. On the other hand, because of a flat LM curve, the IS shifts have the maximum impact on output. As a result, fiscal policy has the maximum impact during a liquidity trap like situation.

Therefore, if the policymakers want to boost the economy, they should go for a boost fiscal policy; i.e. increase government expenditure or reduce taxes to increase output. This is shown in Fig. 3 which shows that where LM curve is relatively flat, change in money supply does not impact the LM curve while IS curve shifts have large impact on the economy. The economic argument is that when interest rate is too low and people are not willing to invest in financial instruments, then government can boost the economy by generating employment which will create demand and then industry will respond to that increased demand and the revival will gradually take place. The monetary policy remains ineffective because increasing interest rate will dampen the borrowers' sentiment and further impact the industry negatively while lowering interest further is not possible as LM has hit its lowest level of interest rate already.

Fig. 2 and 3 are taken from Macroeconomic Theory and Policy by William H. Branson.

Fig. 1

Fig. 2

Fig. 3