28. LIQUIDITY TRAP Flashcards
WHAT IS NOMINAL INTEREST RATE ?
WHEN DO PEOPLE PREFER TO DEPOSIT MONEY IN BANK SAVINGS ACCOUNT
WHAT IS REAL INTEREST RATE
RATE OF INTEREST GIVEN ABOVE INFLATION RATE IN SAVINGS ACCOUNT
What is a liquidity trap?
A situation where monetary policy becomes ineffective as interest rates are near zero and people prefer holding cash.
How does a liquidity trap occur?
It happens when low interest rates fail to increase demand, as people and businesses avoid spending or borrowing.
Why is it called a ‘trap’?
Because people hold onto cash, preventing economic recovery despite low interest rates.
What happens to the nominal interest rate in a liquidity trap?
It falls close to zero, limiting the central bank’s ability to stimulate the economy.
What role does inflation play in a liquidity trap?
Low or negative inflation keeps real interest rates high, discouraging spending.
How does a central bank try to escape a liquidity trap?
By using unconventional policies like quantitative easing, negative interest rates, or fiscal stimulus.
What is the relationship between liquidity trap and deflation?
Deflation increases the real burden of debt, reducing consumption and investment, worsening the trap.
What happens to money supply during a liquidity trap?
Even if the central bank increases money supply, demand remains low, and economic activity does not rise.
What is the Keynesian view on liquidity trap?
Keynesians argue that fiscal policy (government spending) is necessary to boost demand and escape the trap.
How does a liquidity trap affect investment?
Businesses avoid borrowing and investing due to uncertainty about future demand and profitability.
What is the impact of a liquidity trap on economic growth?
Economic growth slows or stagnates as consumers and businesses reduce spending and investment.
Can monetary policy alone fix a liquidity trap?
No, because interest rates are already low, and people are unwilling to borrow even with more liquidity.
What is the role of fiscal policy in escaping a liquidity trap?
Increased government spending can boost demand and create jobs, pulling the economy out of the trap.
Why do people prefer holding cash in a liquidity trap?
Because they expect future interest rates to rise, making bonds and investments unattractive.
How does Japan’s experience illustrate a liquidity trap?
Japan has faced low interest rates and weak demand for decades, requiring aggressive monetary and fiscal policies.
What happens to wages in a liquidity trap?
Wages may stagnate or decline due to low demand and economic uncertainty.
What does ‘pushing on a string’ mean in monetary policy?
It refers to the central bank’s inability to stimulate demand even when increasing money supply.
How do expectations affect a liquidity trap?
If people expect continued low growth, they postpone spending and investment, worsening the situation.
What is the difference between a liquidity trap and a credit crunch?
A credit crunch is a lack of available credit, while a liquidity trap is when people refuse to borrow even with available credit.
What is the Zero Lower Bound (ZLB)?
The point at which nominal interest rates cannot be lowered further to stimulate the economy.
How does government debt impact a liquidity trap?
High government debt may limit fiscal stimulus options, making it harder to escape the trap.
Why do central banks struggle with inflation targeting in a liquidity trap?
Because inflation remains too low, making real interest rates high even at zero nominal rates.
How does consumer confidence affect a liquidity trap?
Low confidence leads to reduced spending and investment, reinforcing the trap.
What is the role of the Phillips Curve in a liquidity trap?
The traditional inverse relationship between inflation and unemployment may break down.
How can inflation help escape a liquidity trap?
Moderate inflation can lower real interest rates and encourage spending and investment.
What historical events have seen liquidity traps?
The Great Depression, Japan’s Lost Decade, and the 2008 Global Financial Crisis.
Can unconventional monetary policies solve a liquidity trap?
They can help but may not be sufficient without fiscal intervention.
Why do central banks implement negative interest rates in a liquidity trap?
To discourage saving and encourage spending and lending.
What are the long-term effects of a liquidity trap?
Prolonged stagnation, weak investment, and slow wage growth.
How can a country prevent falling into a liquidity trap?
By maintaining flexible monetary and fiscal policies and ensuring strong consumer confidence.
