What is liquidity trap?
What is liquidity trap?
Liquidity trap is a situation in which speculative demand function is infinitely elastic. The price of a bond has an inverse relationship with the market interest rate. If the interest rate is very high and people expect it to fall in the future, then the bond prices will rise as they are inversely related to the interest rate. In order to earn capital gains in the future, people will purchase bonds and hence the speculative demand for money will become low. On the contrary, if the interest rate is low, then the bond prices will fall and people will sell their bonds and convert them into idle cash balances. Liquidity trap is an extreme case of the latter situation. When the interest rates are very low, then everyone expects interest rates to go up in the future. Thus everybody prefers to maintain cash balances. Consequently, the speculative demand for money is infinitely elastic. In this situation, if the additional money is pumped into the economy, then this will only satisfy the thirst for money, without increasing the demand for bonds. Pumping additional money in this situation will further aggravate the condition as this will further reduce the interest rate below rmin
The relationship between speculative demand for money and the rate of interest is given as:
In the above diagram, the interest rate is represented on the vertical axis and speculative demand on the horizontal axis; when r = rmin, the economy is in liquidity trap, where the speculative demand for money is infinitely elastic.
Liquidity trap is a situation in which speculative demand function is infinitely elastic. The price of a bond has an inverse relationship with the market interest rate. If the interest rate is very high and people expect it to fall in the future, then the bond prices will rise as they are inversely related to the interest rate. In order to earn capital gains in the future, people will purchase bonds and hence the speculative demand for money will become low. On the contrary, if the interest rate is low, then the bond prices will fall and people will sell their bonds and convert them into idle cash balances. Liquidity trap is an extreme case of the latter situation. When the interest rates are very low, then everyone expects interest rates to go up in the future. Thus everybody prefers to maintain cash balances. Consequently, the speculative demand for money is infinitely elastic. In this situation, if the additional money is pumped into the economy, then this will only satisfy the thirst for money, without increasing the demand for bonds. Pumping additional money in this situation will further aggravate the condition as this will further reduce the interest rate below rmin
The relationship between speculative demand for money and the rate of interest is given as:
In the above diagram, the interest rate is represented on the vertical axis and speculative demand on the horizontal axis; when r = rmin, the economy is in liquidity trap, where the speculative demand for money is infinitely elastic.
