LIQUIDITY TRAP Meaning and
Definition
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A liquidity trap can be defined as a situation in which the central bank's monetary policy becomes ineffective in stimulating economic growth and prices due to a combination of ultra-low interest rates and a lack of consumer and business spending. In this scenario, despite the central bank's effort to increase the money supply by reducing interest rates, individuals and companies refrain from borrowing money or investing, leading to the stagnation of economic activity.
The liquidity trap concept was first introduced by the economist John Maynard Keynes during the Great Depression of the 1930s. It occurs when people and businesses display a preference for holding cash rather than spending or investing, even when interest rates are extremely low. This preference for cash results in a decrease in aggregate demand, leading to deflationary pressures and a sluggish economy.
During a liquidity trap, the central bank's usual tools of monetary policy, such as reducing interest rates or increasing money supply, fail to stimulate economic growth as individuals and businesses prefer to hold onto cash rather than spend or invest. This lack of spending and investment aggravates the situation, prolonging the economic downturn.
To overcome a liquidity trap, unconventional monetary policies may be required, such as quantitative easing or direct injections of money into the economy. The objective is to convince individuals and businesses to spend and invest, thereby stimulating economic growth and escaping the trap.
Etymology of LIQUIDITY TRAP
The term "liquidity trap" was first coined by the economist John Maynard Keynes in his 1936 book "The General Theory of Employment, Interest, and Money". However, its origin can be traced back to the broader concept of "liquidity preference", which Keynes also discussed in his book.
The word "liquidity" comes from the Latin word "liquidus", meaning "fluid" or "liquid". In the economic context, it refers to the availability of liquid assets or cash that can be easily converted into other forms of payment.
The term "trap" implies a situation from which it is difficult to escape or break free. In the case of a liquidity trap, it refers to a scenario in which interest rates are very low, and individuals and businesses have a preference for holding cash instead of investing or spending. This preference for cash results in a lack of effective demand and can lead to a stagnant economy.
