Liquidity Trap

Liquidity Trap is an economic state where interest rates are low and savings rates are high, which renders monetary policies to be ineffective. A gloomy economic outlook causes consumers to be hesitant in purchasing bonds or assets that have a higher yield than cash. Beyond investments, the period includes an overall decrease in economic activity; the decrease in consumption leads to less business hirings and unemployment.

Public Notion
The negative outlook for the economy is shared between individuals and firms. Even when interests are low and investing would mean greater profits, individual investors are hesitant to purchase bonds because of the belief of a potential drop in bond prices (from an anticipated rise in interest rates in the future, which lowers bond prices), and firms are hesitant because they expect a further decrease in consumer demand. Both parties are not compelled to invest by the gloomy economic outlook; the preference to hold cash and fear to invest further diminishes economic activity and perpetuates deflation.

Monetary Policy
In a period of low inflation, the common approach for the government or the central bank would be to increase the money supply, which would decrease interest rates. Following that, the general expectation is a rise in investments. However, during a liquidity trap, interest rates are already low (close to 0) so shifting the money supply will no longer have an impact on interest rates or induce economic activity; during periods of low interest rates, the decision of holding cash or investing money become perfectly elastic.

Fiscal Approach
There have been various approaches, both in theory and in practice, that aim to tackle the liquidity trap throughout history. Classic Keynesian Economics believe in the adoption of fiscal policies to jumpstart economic activity while Japan adopted methods such as quantitative easing and inflation targeting.

Expansionary Fiscal Policy
Keynesian economics, proposed by John Maynard Keynes, suggests that expansionary fiscal policies have the effect of activating private spending. Increased government spending is a expansionary fiscal policy that aims to increase aggregate demand. This typically includes increasing government borrowing and selling bonds to the private sector. Keynes believes this approach to be effective to stimulate economic activity. Additionally, as the demand for employment rises (from the multiplier effect from increased aggregate demand), unemployment will drop down. It is important to underline the importance of proper execution of this measure. When its country encountered the liquidity trap, the Japanese government allocated money to inefficient public works and business going under, resulting in wasted money.

Decrease in income tax is another fiscal approach. This might contain a higher risk than increasing government spending. The aim of decreasing income tax is to increase disposable income in the private sector, thereby potentially stimulating more spending and investments. However, during a liquidity trap, if agents continue to possess a negative economic outlook, an increase in disposable income may not directly lead to an increase in their willingness to spend.

Escaping Liquidity Trap
Looking at Japan in the last two decades of the 20th century (commonly referred to as the "Lost Decades"), we can see the impact within the Japanese economic bubble. Following the appreciation of the Japanese Yen, the Japanese government decided to compensate that through implementing a sharp expansionary monetary policy and advocated its banks to loan more to the private sector. The policy aimed to increase consumption and included a 50% decrease in interest rates. With the lowered interest rates and greater disposable income, the population was able to be involved in real-estate investment. Higher asset demand increased prices as well as collateral value, which caused greater price stimulation. On the other hand, a foul corporate accounting system, Zaitech, that allowed capital gains to be counted as profits accounted for the inflation of the stock market. Higher stock prices meant companies had higher valuations, which increased their power to borrow more money to fuel the bubble. It was too late when the government sensed the negative impacts of this inflation and decided to increase interest rates. The bubble bursted, leaving the majority of corporate Japan in debt. Banks lost monetary power because of the high volume lending, becoming "zombie" banks.

To escape this low-growth period, Japanese academics proposed inflation targeting to manage expectations and increase economic activity, which will in turn decrease real interest rates. The idea was proposed to the BOJ on multiple accounts but was never put in motion. Some skepticism included: interest rates were already at zero-bound, so there were no traditional instruments in place to further lower interest rates; adopting inflation targeting during deflation to stimulate economic growth was unprecedented; economists at the BOJ believed that deflation caused by supply-side shocks may be desired since it showed technological innovation and lower prices; it was difficult to identify an acceptable range of price stability because of the economy's deflationary state, thus expected inflation was unidentifiable; inflation targeting will not achieve its goal in managing expectation because of the low credibility of banks during the time, low expectation of growth was said to remain.

Instead, the BOJ settled on the Zero Interest Rate Policy (ZIRP). ZIRP was in play during two periods of time from 1999 to 2003. The aim of the first period was to eliminate Japan's further deflationary concerns, and the second was to ensure inflation returns to or rises above zero level.

Quantitative easing was also adopted by the BOJ as a more aggressive policy during the early 2000s. The BOJ increased its purchase in asset-backed securities, long-term government bonds and equities to supply commercial banks with large excess reserves, which will allow larger amounts of private lending. Quantitative easing has been deemed an effective measure when short-term interests are near zero level as countries like the US, UK and ones in the EU implemented the measure after the 2008 financial crisis.