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Advantages Of A Liquidity Trap

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Introduction A liquidity trap is a situation where conventional monetary policies are ineffectual because nominal interest rates are of insignificant value. In other words, applying monetary base into the economy is useless because the private sector views the base and bonds as perfect alternatives. Hence, a liquidity trap could occur in an economy with a flexible price or full-employment. The problem, however, in a liquidity trap is that markets believe that the central bank aim at price stability when presented with the opportunity and as a result any current monetary expansion is only short-term. This maintains that monetary policy is ineffective in a liquidity trap and that fiscal expansion is the solution. Monetary policy may be effective if the central bank can convincingly promise to be imprudent to pursue a higher future price level. …show more content…

In consequence with that, banking system and the economy depreciated. The interest rate came towards zero and hence made monetary policy ineffective. This is liquidity trap. Liquidity trap refers to the singularity when increased money supply fails to lower interest rates. At that time central bank try to buy the bonds with newly created cash by lowering the interest rate. In liquidity trap bonds pay no interest so they make them nearly equivalent to cash. So consumers choose to avoid bonds and keep their funds in saving. Japan’s interest rate has been compacted in the direction of zero because of pressure coming through the foreign

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