Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Spotting the Liquidity Trap and Quantitative Easing

Sometimes traditional monetary policy (reducing the interest rate) becomes ineffective because the interest rate is already at (or near) zero – this is known as the liquidity trap. In recent times this has meant that some central banks

have turned to quantitative easing (creating large amounts of new money) in order to stimulate the economy. In this section you discover more about both of these.


Zeroing in on the liquidity trap


The liquidity trap (often also called the zero lower bound problem) has been a big headache for policy makers worldwide for a number of years. It goes something like this. At some point conventional monetary policy becomes ineffective, because increasing the money supply further has no impact on the nominal interest rate; people are already willing to hold as much money as the central bank chooses to supply at that interest rate.

This problem occurs when the nominal interest rate is equal to zero, because the opportunity cost of holding cash is now zero. When you can’t earn a return on your funds anyway, you may as well hold them in cash. After all, cash is the most liquid of all assets, and when the nominal interest rate is equal to zero, you can’t do better than cash anyway.

In Figure 10-6, the money supply is initially represented by S₀ and the equilibrium nominal interest rate is already at zero. Increasing the money supply further to S₁ has no impact on the interest rate, because people are willing to hold unlimited cash if the nominal interest rate is zero! Compare this to the situation in Figure 10-2 where an increase in the money supply does result in a fall in the interest rate when there is no liquidity trap.

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Figure 10-6: Liquidity trap.


Another way of thinking about this situation is as follows: if nominal interest rates are below zero, that is, negative, and you give someone £10, in the future he’d give you back less than £10. You’d be paying him for lending him money, which is crazy! You’d do better keeping hold of your cash.


If you follow the news closely, you may smell a rat here! Highly unusually, recent years have seen a few cases where the nominal interest rate (yield) on some government bonds has been very slightly negative. Therefore, instead of being paid, people were effectively paying those governments for the privilege of lending them money. Why would anyone do that? They must have been so worried that they thought it was safer than putting the money in the bank or even under the mattress! But this situation is exceptionally rare and in ‘less interesting times’ you don’t expect it to happen.

It does leave a problem, however: what are policy makers to do if the nominal

interest rate is already at zero (or very close) and they want to stimulate the economy using monetary policy? Enter quantitative easing!