A liquidity trap occurs when factors that usually stimulate the economy fail to do so, such as a drop in interest rates not motivating consumers to buy more goods and services on credit. John Maynard Keynes developed the theory during the Great Depression, and it can also emerge when consumers suspect interest rates may fall. Lenders can become selective in writing off new debt, and consumers may divert liquid assets into savings accounts, further motivating them to save rather than spend.
Liquidity traps are financial situations in which a factor that usually stimulates the economy fails to get the desired reaction. An example of a liquidity trap is when a drop in interest rates fails to motivate consumers to buy more goods and services on credit. The trap can also develop when most financial assets are tied up in illiquid accounts, making it difficult or impossible to convert those illiquid assets into liquid assets that can be used for new purchases or acquisitions.
John Maynard Keynes is often credited with inventing the concept of the liquidity trap. Keynes first developed this theory during the Great Depression in the United States in the mid-1930s. Basically, Keynes outlined the events of recent years and noted how the events leading up to the 1929 stock market crash and the prevailing attitudes of both lenders and borrowers during the depression created a situation where the usual economic stimulators they weren’t creating the desired effect.
Even when there is no economic depression, a liquidity trap can emerge. When consumers suspect that interest rates may fall below current levels, they may choose to avoid incurring new debt for a period of time. This is true even if interest rates have recently fallen. As long as rates are expected to fall further, consumers will refrain from borrowing money or making major purchases.
Another approach to the liquidity trap focuses on lenders rather than consumers. When lenders perceive that the usual indicators of the money economy point to an increase in loan and credit account delinquencies, they can become highly selective in writing off new debt. This means that consumers who are normally able to obtain credit relatively easily are suddenly unable to obtain credit even at higher interest rates.
Interest rates on savings accounts are often relatively high during a cash trap, while interest rates on loans and credit cards are low. In addition to suspecting that interest rates on credit accounts may go down, consumers may also want to divert liquid assets into savings accounts and take advantage of the high interest on those accounts while they can. This combination of circumstances further motivates consumers to save rather than spend.
Protect your devices with Threat Protection by NordVPN
