Liquidity Traps

Slouch

There's been a lot of talk of liquidity traps recently and the concept still has me rather confused (I don't study economics if you're wondering). Some people still say they exist, but some sources leave me with the impression that the idea is entirely discredited. So, which is it? Please feel free to disagree with each other (I would enjoy it very much ).

Flamed Diving

Well, it depends on the definition. A liquidity trap could simply mean that the Central Bank can no longer affect the economy through targeted interest rates. The most obvious example being the Bank of Japan for the last 20ish years. If you mean a strict application of Keynes liquidity trap then you are not going to find one, because models don't truly reflect reality.

Économiste Monétaire

Yes, liquidity traps exist. Case-in-point: Japan for the last twenty years; interest rates at zero, but with little to no effect on private sector credit demand and the inflation rate. Read Richard Koo's The Holy Grail of Macroeconomics for a good, non-technical exposition.

silverharp

Short summary of Koo's idea of the "Balance Sheet" recession

A balance sheet recession emerges after the bursting of a nationwide asset price bubble that leaves a large number of private-sector balance sheets with more liabilities than assets.
In order to repair their balance sheets, private sector moves away from profit maximization to debt minimization.
With the private sector de-leveraging, even at zero interest rates, newly generated savings and debt repayments enter the banking system but cannot leave the system due to the lack of borrowers.
The sum of savings and debt repayments end up becoming the leakage to the income stream.
The deflationary gap created by the above leakage will continue to push the economy toward a contractionary equilibrium until the private sector is too impoverished to save any money (=depression).
In this type of recession, the economy will not enter self-sustaining growth until private sector balance sheets are repaired.

Slouch

Sorry for taking forever to get back on this forum. I've been busy with other things. First of all I'd like to thank you all for giving me some very nice answers. It really helped simplify it for me.

No, I didn't mean a pure Keynesian liquidity trap where demand is infinitely elastic. Just because I don't do economics doesn't mean I'm a complete half-wit when it comes to discussing it:rolleyes:. I did mean it in the sense that Keynes meant it though, i.e. return on investment falls and investment itself subsequently falls, resulting in a negative cycle towards a liquidity trap. Did I understand it right?

On another note, I actually found the 'holy grail' in Hodges Figgis and was able to afford it with my credit there, but it lost out to another book which I could actually use for my college coursework (my essay wasn't much related to economics). Now you can all discuss my choice in the context of behavioural economics and consumer choices .


Thanks again.

Économiste Monétaire

Slouch wrote: »

related to economics). Now you can all discuss my choice in the context of behavioural economics and consumer choices .


Thanks again.

Slouch

Économiste Monétaire wrote: »

I lol'd

The microeconomists among us will have noticed that the graph doesn't depict a true equilibrium.

God I hate what I've become...

SLUSK

Computers and other home electronics stuff gets cheaper and cheaper all the time, guess that is why nobody is buying computers and home electronics.

With this example I hope I have shown the absurdity of the arguments behind the so called "liquidity trap".

Flamed Diving

SLUSK wrote: »

Computers and other home electronics stuff gets cheaper and cheaper all the time, guess that is why nobody is buying computers and home electronics.

With this example I hope I have shown the absurdity of the arguments behind the so called "liquidity trap".

Hope is a good choice...

Économiste Monétaire

SLUSK wrote: »

Computers and other home electronics stuff gets cheaper and cheaper all the time, guess that is why nobody is buying computers and home electronics.

With this example I hope I have shown the absurdity of the arguments behind the so called "liquidity trap".

This says nothing about the liquidity trap.

billyknowsbest

Trying to understand liquidity traps and came across this sentence- a  possible cause) unwillingness to hold bonds 'if interest rates are zero, investors will expect interest rates to rise some time. If interest rates rise, the price of bonds falls. Therefore, investors would rather keep cash savings than hold bonds.'
Can anybody translate this in to everyday English? If bonds are cheaper why wouldn't investors buy them?

andrew

billyknowsbest wrote: »

Trying to understand liquidity traps and came across this sentence- a  possible cause) unwillingness to hold bonds 'if interest rates are zero, investors will expect interest rates to rise some time. If interest rates rise, the price of bonds falls. Therefore, investors would rather keep cash savings than hold bonds.'
Can anybody translate this in to everyday English? If bonds are cheaper why wouldn't investors buy them?

If interest rates are zero, then interest rates can only go up (mostly). But if the interest rate on a bond rises, then it's market value falls. So, why hold bonds if their price will only be going down in the future? you'd be taking a loss!

In other words, in a liquidity trap bond prices are very high and chances are they'll fall, so people don't hold bonds (is the idea).