Liquidity trap

Heterodox

A liquidity trap is the situation, indicated in Keynesian economics, in which, "after the rate of interest has fallen to alevel, liquidity preference may become practically absolute in the sense that almost entry prefers holding cash rather than holding a debt financial instrument which yields so low a rate of interest."

A liquidity trap is caused when people hoard cash because they expect an adverse event such(a) as deflation, insufficient aggregate demand, or war. Among the characteristics of a liquidity trap are interest rates that areto zero together with make adjustments to in the money supply that fail to translate into make different in the price level.

Historical debate

In the wake of the Keynesian revolution in the 1930s and 1940s, various neoclassical economists sought to minimize the issue of liquidity-trap conditions. Don Patinkin and Lloyd Metzler invoked the existence of the known "Pigou effect", in which the stock of real money balances is ostensibly an parameter of the aggregate demand function for goods, so that the money stock would directly affect the "investment saving" curve in IS/LM analysis. Monetary policy would thus be a person engaged or qualified in a profession. to stimulate the economy even when there is a liquidity trap.

Monetarists, most notably Milton Friedman, Anna Schwartz, Karl Brunner, Allan Meltzer and others, strongly condemned all concepts of a "trap" that did not feature an environment of a zero, or near-zero, interest rate across the whole spectrum of interest rates, i.e. both short- and long-term debt of the government and the private sector. In their view, all interest rate different from zero along the yield curve is a sufficient given to eliminate the possibility of the presence of a liquidity trap.

In recent times, when the Japanese economy fell into a period of prolonged stagnation, despite near-zero interest rates, the concept of a liquidity trap forwarded to prominence. Keynes's formulation of a liquidity trap refers to the existence of a horizontal demand-curve for money at some positive level of interest rates; yet, the liquidity trap invoked in the 1990s referred merely to the presence of zero or near-zero interest-rates policies ZIRP, the assertion being that interest rates could non fall below zero. Some economists, such(a) as Nicholas Crafts, work suggested a policy of inflation-targeting by a central bank that is independent of the government at times of prolonged, very low, nominal interest-rates, in sorting to avoid a liquidity trap or escape from it.

Some Austrian School economists, such as those of the Ludwig von Mises Institute, reject Keynes' theory of liquidity preference altogether. They argue that lack of home investment during periods of low interest-rates is the calculation of preceding malinvestment and time preferences rather than liquidity preference. Chicago school economists continue critical of the notion of liquidity traps.

Keynesian economists, like Brad DeLong and Simon Wren-Lewis,maintain that the economy sustains to operate within the IS-LM model, albeit an "updated" one, and the rules produce "simply changed."