.

Free Economics Essay on Keynesian Liquidity Trap

John Maynard Keynes, a British economist, in 1936 mention liquidity trap in his book General Theory. He mentioned this concept as, ‘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 hold a debt which yields so low a rate of interest’. However, Keynes was not the first economist to mention the concept of a liquidity trap. Sir John Richard Hicks explained this concept before Keynes

This concept can be better explained with the help of liquidity preference theory, given by Keynes.

MEANING

Liquidity preference can be understood as a preference to hold cash, as cash is the most liquid asset consumers like to hold it. This preference to hold money is known as demand for money. In other words, demand for money is determined by the liquidity preference of the consumers in the market. This concept was introduced by Keynes, for the first time, in his book General theory (1936). He used this concept in the explanation of interest rate determination.

The interest rate is generally determined with the help of two things. When demand for money equals the supply of money in the economy, the interest rate is defined. Graphically, when the demand curve of money and supply curve of money interest for each other, then the point of intersection gives us equilibrium level of interest.

DEMAND FOR MONEY

According to Keynes money is demanded by the individuals mainly because of three reasons. These are the three types of demand for money. Let us briefly understand the three main reasons behind the demand for money.

First observed reason is TRANSACTION MOTIVE also known as transaction demand for money. The demand for money for day to day purposes is seen as transaction demand for money. The daily activities need money for maintenance and usually, the income generated is received after a short duration for example after a week, fortnight, month whereas expenses are met on a daily basis. This gap creates the liquidity preference i.e. demand for money.

Demand for Money

Second observed reason is PRECAUTIONARY MOTIVE also known as precautionary demand for money. Life is uncertain and so nobody knows when they might need money and to cover themselves and to be able to meet unforeseen contingencies (unemployment, accident, etc.) people hold their money. The amount held by individuals differs and depends on the income.

The third observed reason is SPECULATIVE MOTIVE also known as speculative demand for money and is a pure contribution of Keynes. It can be understood as the desire to hold cash or assets in liquid form in order to take advantage of fluctuations in the market regarding the changes in the interest rates. Money is demanded to make speculative gains by trading bonds and securities whose prices and rate of interest fluctuate inversely.

TOTAL DEMAND OF MONEY is the sum total of all three types of demand for money. The curve of demand for money has a negative slope and slopes downward from left to right this happens due to the presence of a converse relationship between the speculative demand for money and interest rates.

SUPPLY FOR MONEY is assumed to be constant as it is controlled by the central bank of the country. For example, a Federal bank in the U.S. controls the money supply.

Now comes the important topic of this article. Even though the downward sloping demand for money curve or liquidity preference curve becomes perfectly elastic at low-interest rates. But Keynes laid stress on the phenomenon, where there is a floor interest rate below which the interest rate cannot fall. This is what Keynes explained as ‘liquidity trap’. This is the minimum rate of interest which indicates absolute liquidity preference of the people i.e. people want to hold their money and do not want to invest their money in bonds etc.

Liquidity Trap

In the above figure, there is an increase in the initial money supply and supply of money curve MS1 shifts to MS2 but there is insignificant or no change in the rate of interest. MS2 later shifts to the right at MS3 but even then the rate of interest remains sticky and does not fall. This horizontal line at the end of the money demand curve is the area which depicts the liquidity trap. Liquidity Trap is a situation in which the central bank of the country increases the supply of money (printing new currency and adding it), etc. into the market with an aim of helping the economy to improve but fails to lower the interest rates. In times of downturn, an economy can face the problem of short-term interest rates reaching zero. In this situation monetary policy becomes fruitless and there arises a need for an external catalyst. The central bank does so by purchasing financial assets of longer maturity from commercial banks with an aim of lowering the long-term interest rate. A liquidity trap takes place when actions like these fail to lessen the long-term interest rate. It can be also understood as a situation where nominal interest is zero.

CRITICISMS

In economics, there are innumerable concepts which are criticized by the economists from a different school of thought. Keynes liquidity trap is also one of them. Economists from the Chicago and Austrian schools of economic thought discard the existence of a liquidity trap completely. The argument that they use in their defense is that the lack of home investment during periods of low-interest rates is not because of the people’s desire for holding cash in their hands but it is because of the poor allocation of investments and time preference.

MODERN LIQUIDITY TRAP

Some economist believes that the global economic meltdown of 2008 brought a liquidity trap to a number of countries. Economist Paul Krugman, in 2010 said that almost all developed countries are in one. Japan has been struggling to make its economy steady for over 20 years. The asset price bubble in Japan is seen as an example of a liquidity trap by Paul Krugman. The US got acquainted with the trap for the first time – since the Great Depression of 1929 – following the advent of the recession in 2008. Both of these countries now maintain their interest rate at zero level and use different monetary policies.

.