Liquidity Trap

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In his 1936 “General Theory Of Employment, Interest and Money,” John Maynard Keynes discussed what he called the liquidity trap. The trap occurred when demand had pushed bond prices – think U.S. Treasury securities – so high that they could rise no further. At that point, in an economy awash in liquidity, interest rates hit rock bottom at barely above zero.

Keep in mind that bond prices and interest rates very inversely. Let’s say a 30-year bond sells for $1,000 and pays $50 annual interest for a 5% yield. If at any time in those 30 years the bond’s purchaser sells the bond, the change in the bond’s price will determine the rate of interest (yield) because the bond always pays $50 annually. For instance, if heavy demand for the bond pushed its price up to $2,000, then the yield would be roughly 2-1/2% ($50/$2,000 = 2-1/2%). If weak demand reduced the bond’s price to $500, then the yield would have risen to roughly 10% ($50/$500 = 10%).

In a weak economy, said Mr. Keynes, businesses had excess funds because of the dearth of projects in which to invest those funds. These circumstances prompted businesses to purchase bonds with their excess funds in order to earn a return on those funds. Unfortunately, excess liquidity could prompt massive demand for bonds, pushing their prices upward and their yield downward. Since the yield could not fall below zero, that set an upward boundary on bond prices.

When bond prices reached their maximum and bond yields dipped to their minimum, the economy was in the liquidity trap. The trap rendered monetary policy useless because the central bank could not further depress interest rates in order to implement an expansionary monetary policy. If business required lower rates before it purchased more plant and equipment, business would be disappointed. Rates could not fall and therefore business investment would not rise. The economy was stuck in the trap.

Our economy may be in, or close to, a liquidity trap today. Yields on some Treasury securities have briefly fallen to zero. The Federal Reserve is contemplating a drop in the federal-funds rate to less than 1%. Will this prompt business to invest more (purchase additional plant and equipment)? Probably not. Will households buy more homes and cars? That remains to be seen. The direction of home prices and employment will play an important role.

If the economy is caught in a liquidity trap, traditional monetary policy can have little effect.

© 2008 Michael B. Lehmann