Liquidity Trap

The economic situation in a wide range of economies in the wake of the crisis that began in 2007 is characterised by many as a liquidity trap. The original conceptualization of the liquidity trap was part of Keynes’s (1936) theory of liquidity preference. It referred to a situation where the monetary authorities could not reduce the nominal long-term interest rate any further by selling bonds because of the near universal expectation that interest rates were so low that they could only rise and bond prices fall. “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 holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest” (Keynes, 1936, p. 207). In principle, the liquidity trap could arise at any interest rate; the critical factor was that a conventional expectation should have been formed that interest rates would not fall further. Given that such a belief was formed under uncertainty, it was potentially volatile. But Keynes had proceeded to explain that, while a liquidity trap had occurred under special circumstances, it was in general unlikely.