What is this “Liquidity Trap”?

The Liquidity Trap is an idea that originates as an extreme case scenario in Keynesian monetary theory which became reality in Japan in the 1990s, as an isolated phenomenon in modern international economics.

Keynesian theory outlines that money supply influences prices and economic output through the nominal interest rate. This then suggests that increasing money supply reduces the interest rate through a money-demand equation, which will in turn stimulate economic output and consumption. The short-term nominal interest rate cannot be negative, otherwise there is a “free-lunch” for borrowers i.e. if lenders give x amount and expect less than x in return, borrowers will have made a no risk profit.  So there must therefore be a “zero bound” on the short-term nominal interest rate.

Keynes inferred that once money supply has been increased to some level where the short-term interest rate is zero; there will be no further influence on economic output or prices by increasing money supply. This scenario is known as the “Liquidity Trap”.

Or more elegantly described by John Hicks (1937) as, that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant because money and bonds are essentially perfect substitutes.

Modern descriptions of the Liquidity Trap centre on an intertemporal stochastic general equilibrium model, where aggregate demand depends on current and expected future interest rates. The equilibrium trap still occurs when the short-term nominal interest rates are sufficiently close to the zero bound, and central bank is unable to compensate for large deflationary shocks through monetary policy. It’s still the same cake with more trimmings, but just as hard to swallow.