A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. This is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.”
Cause of negative shocks to aggregate demand:
· bursting of an asset-price bubble
· correction of overoptimistic growth and productivity expectations
· increased doubts about future pensions and benefits due to demographic developments and/or reckless fiscal policy
· increased uncertainty for geopolitical (War)
Normal Central Bank Action for recovery
↓short nom. interest rate – ↓short real interest rate – ↓long real rates – ↑aggregate demand – ↑inflation expectation – ↑inflation.
Where it doesn’t work
↓short nom. interest rate too small to stimulate the rest of the chain effect
Solutions:
· an explicit central-bank commitment to a higher future price level. You
· a concrete action that demonstrates the central bank’s commitment, induces expectations of a higher future price level and jump-starts the economy
· An exit strategy that specifies when and how to get back to normal. A currency depreciation is a direct consequence of expectations of a higher future price level and hence an excellent indicator of those expectations. Furthermore, an intentional currency depreciation and a crawling peg, can implement the optimal way and, in particular, induce the desired expectations of a higher future price level.
