What is a liquidity trap? A Liquidity trap emerges when interest charges are nil or during a downturn. People are afraid to spend money. They feel safe to just hold onto the cash. Due to such circumstances, central banks consuming expansionary monetary policy doesn’t improve the economy.
In simple words, a liquidity trap meaning is when monetary policies don’t effectively work. Though a liquidity trap is a purpose of economic states, it is also intellectual since customers are choosing reserve cash instead of making big investments because of a turndown economic scenario.
Read the article till the end to understand everything about this trending topic from the UPSC perspective.
Liquidity Trap Meaning
A liquidity trap isn’t restricted to bonds. It also influences other parts of the economy, as consumers are devoting less cash on products which predicts that businesses are having fewer chances to get hired.
The most significant thing to keep in mind while understanding the liquidity trap and its implications are its out-turn on stock and bond markets, accordingly.
Financing in equity is affected majorly as people are doubtful about the production of companies in the near future. This decreases the cash flows of these businesses.
In the view of liquidity traps, people desire the interest rate levels to increase from negligible levels over time, thereby tending to a depletion in the bond charges.
Hence, afraid of capital losses, people favour hoarding money in cash or savings account instead of financing the same.
Thus, the expansionary monetary policy through lowering interest rates fails to develop any effect in boosting investment levels in a country.
What Causes a Liquidity Trap?
There are mainly four signs giving rise to liquidity traps. All of them show that the efforts of central banks to raise the economy are totally ineffective. Below are the four signs that every UPSC aspirant should know.
Rates of Interest Getting Low
The major sign of a liquidity trap is the consistently low rate of interest levels directed by the central bank of a country for a long period of time. Though the main goal of such government policies is to secure robust economic activity, a liquidity trap can soon rise if not operated firmly.
Generally, a liquidity trap emerges when an economy is recuperating from a fall. As governments try to raise economic expansion through expansionary policies to enlarge spending and investment, a diametric effect through an increase in savings level is observed in the market if interest rates are kept too low (close to zero) for a prolonged period.
An effect of the downturn is rushing levels of unemployment in a country, which intimate decreased incomes in the hands of customers. With a lower fund base, people tend to save any excess funds for meeting any future expenses, instead of devoting them. Thus, a fall in interest rates leads to yield no outcome concerning the betterment of an economy.
Depressed customer demand levels lead to turndown in the price level of an economy. Such trends have a bad effect on the economic growth rate of a country, as it degrades producers from producing greater quantities in turn to lower profits. This develops a harsh impact on the GDP of a country.
Formula for Liquidity Trap is
One of the most significant strategies of dominating the liquidity trap in economics is through expansionary fiscal policy. An enlarged government devoting coupled with lower taxes has a productive impact on an economy, as it raises production, which, in turn, exceeds employment levels in a country.
Subsequently, as people have greater disposable income at hand for spending, a rise in the accumulated demand levels is observed, as well as a rise in the investment methods.
A huge depletion in the price level can also rise the spending patterns of people, consequently breaking the pattern of reserving money and ongoing liquidity trap view.
Increase in Interest Rates
A rise in short-term rates motivates people to invest and save their cash, instead of reserving it. The scheme of keeping higher rates of interests for a prolonged period demotivates people and in turn, encourages banks to supply since they will get a greater return. That raises the velocity of money.
Price Drop Enough
If the economy would decrease prices to such a low point that people just cannot resist themselves from shopping. This can happen with customer products or assets like stocks. Investors will start purchasing goods again because they are aware they can hold onto the asset for a long run to survive the slump. The future honour has become greater than the danger.
The Policy of Expansionary Fiscal
The government can abandon the liquidity trap through expansionary fiscal policy. That’s either a tax gash or a rise in government spending, or both. That generates motivation that the nation’s leaders will assist economic growth. It also directly develops jobs, decreasing unemployment and the need for reserving cash.
Fourth, financial innovation generates fresh market liquidity makes financial assets, like stocks, bonds, or derivatives, more glamorous than hoar.
The liquidity trap develops when people are afraid of investing due to low rates of interest. They prefer hoarding cash to ensure themselves for a better future. The central bank cannot raise the economy because there is no command. There are various formulas to vanish the liquidity trap.
Some methods are dependable on the nation’s central bank and federal government. The effective way of decreasing the rate of interest encourages people to invest rather than hoarding cash. The government can spend more and develop motivation in people.
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