Liquidity Trap Explained with Graphs
The liquidity trap is a situation that arises in economics when the money markets are unresponsive to the price of money i.e. interest rates. The possibility of such a situation arising had, until recently, been considered a theoretical abstraction with no historical examples in the real-world.
However, since the 2008 financial crisis, interest rates have remained at historically very low levels, and the liquidity trap theory has been receiving a lot more attention in the economics field since that time.
The theory itself was originally developed from the ideas of John Maynard Keynes, and regardless of whether it is a theoretical abstraction or a real-world phenomena it does raise some interesting concepts that help to develop our general understanding of economics.
In the economic analysis that follows we use the simplifying assumptions that there is no significant inflation in the economy, and therefore the nominal interest rate is equal to the real interest rate.
The Liquidity Trap & IS-LM Graph Analysis
Using the basic IS-LM model to illustrate the liquidity trap shows that any fiscal stimulus policy in the economy, such as increased government spending or a tax cut, will have no effect on the interest rate.
In words, the fiscal stimulus will directly boost the economy and lead to a higher income/output level. For example, consider a new government funded infrastructure project to build a new bridge that will reduce commuter times for workers and improve access to new markets for consumers on either side of the bridge.
This project will not only lead to more commercial activity, it will also directly increase salaries for construction workers and provide extra revenues for the suppliers of the raw materials that went into building the bridge. As a result of this, a new IS curve emerges, shifting from IS1 to IS2, which represents the increased spending in the goods market.
If Keynesian economic theory is correct, and there is spare capacity in the economy to sustain an increased level of income/output without raising the current price level, then the economy can grow from its original level of output at Y1 to Y2. This occurs at the new intersection of the IS2 curve with the LM curve in the diagram.
So far this is all standard stuff.
However, the extra spending in the economy, and the higher income/output level, will lead to an increase in demand for money. This is because people will wish to hold more money in order to increase their purchasing power in the marketplace. The LM curve represents the money market, and in normal times any extra demand for more money (purchasing power) will lead to an increase in the price of money, i.e. an increase in the interest rate.
This is where the liquidity trap comes in, because a normal LM curve should be upward-sloping representing a higher cost of money as demand for it increases, but in a liquidity trap the LM curve is horizontal. The upshot is that regardless of the demand for more money to increase purchasing power, the interest rate is not affected.
The question is why, and what circumstances might cause this to happen? Before moving on to that question, let's briefly turn away from the liquidity trap implications for fiscal policy, and have a look instead at the implications for monetary policy.
Monetary Policy Economics under the Liquidity Trap
Notice in the diagram that, with a horizontal LM curve, monetary policy (rather than fiscal policy) is totally useless. Any attempt by the Federal Reserve Bank to boost the money-supply with lower interest rates (i.e. shifting the LM curve to the right to a new intercept point with the IS curve) is impossible.
This situation can arise only in times when the interest rate is already at or near to zero, because at any other time the central bank can always cut its base rate (called the 'bank rate') if it chooses to do so.
However, when the rate is already as low as it can go, shifting a horizontal curve to the right will always intercept the IS curve at the same point, with the same income/output level, and the same interest rate.