Liquidity Trap

Liquidity Trap Definition

Liquidity Trap is a scenario in which the central bank adds money into the market with the goal of stimulating the economy, but fails to lower the interest rates. In times of recession, an economy can be faced with the problem of short-term interest rates reaching or nearing zero. This makes the monetary policy ineffective, and an external catalyst is besought to stimulate the economy. The central bank does so by purchasing financial assets of longer maturity from commercial banks with the intent of lowering the long-term interest rate. A liquidity trap takes place when these actions fail to lower the long-term interest rate.


Liquidity Trap and the Zero Lower Bound

Liquidity Trap is often confused with another macroeconomic concept called the Zero Lower Bound Problem (ZLBP). In ZLBP, the intervention from the central bank pulls down the interest rate to zero and the economy cannot be stimulated anymore, because the interest rate cannot go any lower. [1] Liquidity Trap differs from ZLBP owing to the fact that even after involvement of the central bank in both cases, in ZLBP, the interest rate can’t get any lower, whereas in liquidity trap, the interest rate doesn’t get lowered at all.


History of the Concept of Liquidity Trap

The invention of the concept of liquidity trap is often credited to John Maynard Keynes. Back in the mid-1930s, when the concept was first ever being discussed, he described it as a situation in which a factor that is put to use to stimulate the economy fails to deliver the desired results. According to this definition, even the failure in encouraging spending after decreasing interest rates can be a liquidity trap. [2]

The concept was perceived very differently from what it is perceived today. The opinion held back in those days was that once the money supply has been increased to a level where the short-term interest rate is zero, there will be no further effect on either prices or output, no matter by how much money supply is increased. The modern framework believes that liquidity trap arises when the zero interest rate prevents the central bank from sustaining effects of deflation with the help of the ability to reduce interest rates.[3]


Liquidity Trap Today

According to some economists, the global economic meltdown that started in 2008 brought liquidity trap to a number of countries. In 2010, the renowned economist Paul Krugman even went as far as saying that almost all developed countries are in one. He mentioned US, Japan, UK, and the Eurozone in particular whilst excluding Australia. [4] Although there are economists like Ludwig von Mises and others who reject the idea of liquidity trap altogether, and thus, do not believe that US or any country can be in a liquidity trap. [5]

Japan has been struggling to make its economy steady for over 20 years. Her asset price bubble (which is also known as the Lost Two Decades) has been called an example of liquidity trap by Paul Krugman. [6] The United States as well got acquainted with the trap for the first time – since the Great Depression of 1929 – following the advent of the recession in 2008. Both the countries have been largely maintaining their interest rates near zero ever since, and have taken the help of the unconventional monetary policy called Quantitative Easing to stimulate the economy. [7]



  2. The General Theory of Employment, Interest, and Money by John Maynard Keynes (1936)
  3. The New Palgrave Dictionary of Economics by Gauti B. Eggertsson (2006)
  6. The Return of Depression Economics and the Crisis of 2008 by Paul Krugman (2009)



Quantitative Easing

Zero Lower Bound

Leave a Reply

Your email address will not be published. Required fields are marked *