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Concept
Liquidity trap
Summary
A liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone 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 hold cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Among the characteristics of a liquidity trap are interest rates that are close to zero and changes in the money supply that fail to translate into changes in the price level.
John Maynard Keynes, in his 1936 General Theory, wrote the following: There is the possibility...that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto.
This concept of monetary policy's potential impotence was further worked out in the works of British economist John Hicks, who published the IS–LM model representing Keynes's system. Nobel laureate Paul Krugman, in his work on monetary policy, follows the formulations of Hicks: A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because [monetary] base and bonds are viewed by the private sector as perfect substitutes. In a liquidity trap, people are indifferent between bonds and cash because the rates of interest both financial instruments provide to their holder is practically equal: The interest on cash is zero and the interest on bonds is near-zero.
Official source
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