Don't Want A Liquidity Trap? More Saving Is The Answer

With interest rates in many countries close to zero or even negative, some commentators are of the view that monetary policy of the central banks are likely to become less effective in navigating the economy. In fact, it is held that we have most likely reached a situation that the economy is approaching a liquidity trap. But what does this mean?

In the popular framework of thinking that originates from the writings of John Maynard Keynes, economic activity is presented in terms of a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by yet another individual becomes part of the first individual's earnings.

Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reason — have decided to cut down on their expenditure and raise their savings.

For instance, if for some reason people have become less confident about the future, they will cut back their outlays and hoard more money. Therefore, once an individual spends less, this will worsen the situation of some other individual, who in turn also cuts his spending.

A vicious cycle sets in — the decline in people's confidence causes them to spend less and to hoard more money, and this lowers economic activity further, thereby causing people to hoard more, etc.

Following this logic, in order to prevent a recession from getting out of hand, the central bank must lift the growth rate of money supply and aggressively lower interest rates.

Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby re-establishing the circular flow of money. Or so it is held.

In his writings, however, Keynes suggested that a situation could emerge when an aggressive lowering of interest rates by the central bank would bring rates to a level from which they would not fall further. As a result, the central bank will not be able to revive the economy.

This, according to Keynes, could occur because people might adopt a view that interest rates have bottomed out and that rates should subsequently rise, leading to capital losses on bond holdings. As a result, people's demand for money will become extremely high, implying that people would hoard money and refuse to spend it no matter how much the central bank tries to expand the money supply.

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