[PDF Notes] Here is your essay on the Liquidity Trap

An important feature of the speculative demand curve is that if the current rate of interest falls to a very low level (say Oi*), the L2 curve becomes perfectly elastic. It means that at this extremely low rate of interest, people have no desire to lend money and will keep the whole money with them.

This is the minimum critical value of the current rate at which every one becomes a money holder because holding bonds means a net loss.

Liquidity trap represents a subjective minimum level of interest rate. Here virtually everyone is convinced that the market rate of interest is below the expected or normal rate of interest.

At such a low interest rate, bonds are considered so risky that the speculators are prepared to hold limitless amount of money.

The yield on the earning assets (bonds) is so low and the risk of holding earning assets is so high that the wealth holders are not ready to keep earning assets and decide to substitute money for earning assets.

The rate of interest becomes sticky and cannot decline further after reaching a critically low level because of the following reasons:

1. Compensation for Cost and Inconvenience:

Investing in bonds involves certain cost and inconvenience and some minimum return (in the form of interest earning) is required to neutralise this cost and incon­venience. So rate of interest must remain positive and cannot become zero.

2. Possibility of Rise in Interest Rate:

When the rate of interest reaches its lowest level, there is every possibility that it will increase and the bond prices will fall in the near future. The speculators will under such circumstances prefer to sell their already held bonds, postpone their purchases of new bonds and keep money with them.

3. Expectation of Capital Gains:

At the very low level of interest rate, the investors hope that the rate of interest will increase and reach its normal level. A rise in the interest rate from an extremely low level involves ‘ greater capital losses than a rise in the interest rate from a relatively higher level.

4. Preference for Money:

At the very low level of rate of interest, people develop a strong preference for holding wealth in the form of money rather than in the form of bonds and securities.

The policy implication of the liquidity trap is that the rate of interest cannot be lowered any more and the monetary policy becomes ineffective in the liquidity trap region of the speculative demand for money curve. Changes in the money supply will have no effect on the interest rate.

During such periods, interest rates arc already very low and the economy is in the flatter ranges of the speculative demand for money curve, and therefore, changes in the money supply cannot further reduce the rate of interest.

Thus, expansionary monetary policy is ineffective during depression. The analysis of the liquidity trap, therefore, explains why Keynes considered monetary policy ineffective and hence favoured fiscal policy which influences aggregate demand and in turn employment and output through changes in government expenditure and taxes, leaving the rate of interest unaffected.

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