Posted by: Ravi Saraogi | April 28, 2009

Liquidity Trap: Revisited

I had touched on the concept of liquidity trap in my previous few posts. I am revisiting the concept here in this small post for the benefit of those who might not still be clear about it. Look at the graph below.

liquidity-trap

It basically plots the benchmark interest rate set by the major cental bankers against time. What do you see? The benchmark interest rates for US has hit the zero lower bound while for UK and EU, they are very close to zero. Obviously, interest rates cannot turn negative. Now look at the graph below-

inflation

The inflation rate in the US has turned negative at -0.38 per cent for the month of March 2009 after a continued and sharp fall since July 2008. Let us compute the real interest rate in March 2009 for the US, which is defined as nominal interest rate minus inflation-

Real Interest Rate = 0.00 – (-0.38) = 0.38 per cent

Definitely low by any standards. However, consider what the real interest rate would have been if the inflation was something like 3.85 per cent (the average inflation rate in the US for the year 2008),

Real Interest Rate = o.oo – 3.85 = -3.85 per cent

Yes, a negative real rate of interest, which would have offered a much larger boost to the economy and given greater traction to the monetray policy operations of the Federal Reserve. As the economy heads deeper into deflation, even with the benchmark interest rates kept at zero, the real rate of interest, reflecting the acutal cost of borrowing, will keep on rising. The above situation is referred to as a liquidity trap and it is easy to see that the monetray policy becomes completely ineffective in influencing the economy, with fiscal policy being the only tool in the hand of the government to bring the economy out of a recession.

Published by: Ravi Saraogi

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