Wednesday, July 8, 2009

liquidity trap and monetary policies

A liquidity trap is a problem in the use of monetary policy - a situation in which increasing reserve does not increase the money supply, but simply leads to excess reserve. A liquidity trap occurs when individuals believe that interest rates are much more likely to rise than to fall. If interest rates rise, bond prices fall, which means that bond holders lose money, so individuals want to hold cash rather than bonds. This means that increases in reserves do not affect interest rates, and do not affect borrowing. This is what happened in Japan in the late 1990s and early 2000s. The bank of Japan (the Japanese central bank) lowered the interest rate (the one similar to the fed funds rate in the U.S.) to 0.01 percent with little effect on investment spending. The belief that increases in the money supply would be ineffective in the 1930s led early Keynesians to focus on fiscal policy rather than monetary policy as a way of expanding the economy. They likened expansionary monetary policy to pushing on a string. The same problem exists with using contractionary monetary policy. Banks have been very good at figuring out ways to circumvent cuts in the money supply, making the intended results of contractionary monetary policy difficult to achieve.

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