Many commentators are of the view that the US central bank should pursue policies that will prevent the possible decline of the economy into a liquidity trap hole. What is this all about?
In the popular framework of thinking that originates from the writings of John Maynard Keynes, economic activity is 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 their outlays and hoard more money. Therefore, once an individual spends less, this will worsen the situation of some other individual, who in turn also cuts his spending.
A vicious circle sets in – the decline in people’s confidence causes them to spend less and to hoard more money, and this lowers economic activity further, thereby causing people to hoard more, etc.
Following this logic, in order to prevent a recession from getting out of hand, the central bank must lift the growth rate of money supply and aggressively lower interest rates.
Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby re-establishing the circular flow of money, so it is held.
In his writings however, Keynes suggested that a situation could emerge when an aggressive lowering of interest rates by the central bank would bring rates to a level from which they would not fall further. As a result, the central bank will not be able to revive the economy.
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