Reviewed by Sep 30, 2020| Updated on
Liquidity trap refers to a situation where the expansionary monetary policy does not lead to an increase in the interest rate or income and, in turn, the economic growth. Here, expansionary monetary policy means an increase in the money supply.
A liquidity trap occurs when the interest rates are low, and savings are high; the situation makes the monetary policy ineffective. In such cases, consumers choose savings accounts over bonds with the belief that the interest rates of savings accounts will rise. When there’s a rise in interest rates, it will push the bond prices down as they maintain an inverse relationship.
There would be no effect on interest rates when a country’s reserve bank, like that of the Reserve Bank of India, tries to stimulate the economy by increasing the money supply. This is to discourage holding additional cash.
Consumers continue to maintain their funds in deposit accounts instead of placing them in investment accounts even when RBI tries to inject additional funds to stimulate the economy. Higher the consumer savings levels, more is the probability of an adverse economic event on the horizon.
A future adverse event is inescapable when consumers hold on to cash and sell bonds. It will eventually drive down the bond prices, and yields rise. Even with increasing yields, consumers lose interest in buying bonds since bond prices are falling. They may choose cash over a lower return.
A significant hint of a liquidity trap is low-interest rates. It affects bondholder behaviour and builds concern regarding the country’s financial state. The volume of bonds being sold will affect the economy negatively. The additional funds injected by the Central Bank fails to bring about price level changes since consumers fixate on low-risk ways of saving.
In addition to low-interest rates, there have to be very few bondholders willing to hold on to their bonds and limited investors who wish to buy them.