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THE LIQUIDITY TRAP, IN KEYNESIAN ECONOMICS, IS A SITUATION

WHERE MONETARY POLICY IS UNABLE TO STIMULATE AN ECONOMY,

EITHER THROUGH LOWERING INTEREST RATES OR INCREASING THE

MONEY SUPPLY.LIQUIDITY TRAPS TYPICALLY OCCUR WHEN

EXPECTATIONS OF ADVERSE EVENTS (E.G.,DEFLATION, INSUFFICIENT

AGGREGATE DEMAND, OR CIVIL OR INTERNATIONAL

CONCEPTUAL EVOLUTION

In its original conception, a liquidity trap results when demand for money becomes infinitely

elastic (i.e. where the demand curve for money is horizontal) so that further injections of moneyinto the economy will not serve to further lower interest rates. Under the narrow version ofKeynesian theory in which this arises, it is specified that monetary policy affects the economyonly through its effect on interest rates. Thus, if an economy enters a liquidity trap, furtherincreases in the money stock will fail to further lower interest rates and, therefore, fail tostimulate.

In the wake of the Keynesian revolution in the 1930s and 1940s, various neoclassical economistssought to minimize the concept of a liquidity trap by specifying conditions in which expansivemonetary policy would affect the economy even if interest rates failed to decline. Don Patinkinand Lloyd Metzler specified the existence of a "Pigou effect," named after English economist

Arthur Cecil Pigou, in which the stock of real money balances is an element of the aggregatedemand function for goods, so that the money stock would directly affect the "InvestmentSaving" curve in an ISLM analysis, and monetary policy would thus be able to stimulate theeconomy even during the existence of a liquidity trap. While many economists had seriousdoubts about the existence or significance of this Pigou Effect, by the 1960s academiceconomists gave little credence to the concept of a liquidity trap.

The neoclassical economists asserted that, even in a liquidity trap, expansive monetary policycould still stimulate the economy via the direct effects of increased money stocks on aggregatedemand. This was essentially the hope of the Bank of Japan in the 1990s, when it embarked uponquantitative easing. Similarly it was the hope of the central banks of the United States andEurope in 20082009, with their foray into quantitative easing. These policy initiatives tried tostimulate the economy through methods other than the reduction of short-term interest rates.

When the Japanese economy fell into a period of prolonged stagnation despite near-zero interestrates, the concept of a liquidity trap returned to prominence.[1] However, while Keynes'sformulation of a liquidity trap refers to the existence of a horizontal demand curve for money atsome positive level of interest rates, the liquidity trap invoked in the 1990s referred merely to thepresence of zero interest rates (ZIRP), the assertion being that since interest rates could not fall

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below zero, monetary policy would prove impotent in those conditions, just as it was asserted tobe in a proper exposition of a liquidity trap.

While this later conception differed from that asserted by Keynes, both views have in commonfirst the assertion that monetary policy affects the economy only via interest rates, and second the

conclusion that monetary policy cannot stimulate an economy in a liquidity trap.

Much the same furor has emerged in the United States and Europe in 20082010, as short-termpolicy rates for the various central banks have moved close to zero.[2]

In October 2010, Nobel laureate Joseph Stiglitz explained how the U.S. Federal Reserve wasimplementing another monetary policycreating currencyto combat the liquidity trap.[3]Stiglitz noted that the Federal Reserve intended, by creating $600 billion and inserting thisdirectly into banks, to spur banks to finance more domestic loans and refinance mortgages.However, Stiglitz pointed out that banks were instead spending the money in more profitableareas by investing internationally in emerging markets. Banks were also investing in foreign

currencies which, Stiglitz and others point out, may lead to currency wars while China redirectsits currency holdings away from the United States.

ar) make persons with liquid assets unwilling toinvest.