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What Is the Liquidity Trap?

What Is the Liquidity Trap?


Some economists such as a Nobel Laureate Paul Krugman are of the view that if the US were to fall into liquidity trap the US central bank should aggressively pump money and aggressively lower interest rates in order to lift the rate of inflation. This Krugman holds will pull the economy from the liquidity trap and will set the platform for an economic prosperity. In his New York Times article of January 11, 2012, he wrote,

If nothing else, we’ve learned that the liquidity trap is neither a figment of our imaginations nor something that only happens in Japan; it’s a very real threat, and if and when it ends we should nonetheless be guarding against its return — which means that there’s a very strong case both for a higher inflation target, and for aggressive policy …(of the central bank).

But does it make sense that by means of more inflation the US economy could be pulled out of the liquidity trap?

The Origin of the Liquidity-Trap Concept

In the popular framework of thinking that originates from the writings of John Maynard Keynes, economic activity presented in terms of a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual’s earnings.

Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reasons — have decided to cut down on their expenditure and raise their savings.

For instance, if for some reason people have become less confident about the future, they will cut back on their outlays and hoard more money. Therefore, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.

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