Economies around the world are in a liquidity trap.

Conventional monetary
policy will not be sufficient to generate recovery’. Explain this statement and
discuss the alternative policy responses and their costs and benefits with
reference to the US or the UK

In March 2009 Bank of England (BoE) cut the interest rate to 0.5 % and it was
maintained throughout the year and may continue well into 2010 (a monetary policy
measure). VAT was also dropped from 17.5% to 15% in early 2009 (a fiscal policy
measure) (BoE 2009). These measures were triggered by the recent crises in the
global financial system, which has its root well in 2007 with nationalisation of
Northern Rock. However, the problem much worsened in 2008 with the collapse of
Lehman Brothers in the US. This failure, caused by risky lending of sub-prime
mortgages, had a knock-on effect on the rest of the world. Governments stepped in
to bailout the banks with large quantities of money. Interest rates were driven to
zero, fiscal measures seemed not sufficient, economies around the world, major
developed economies practically, had entered a Liquidity Trap (LT). The situation
called for extraordinary unconventional measures. In this paper I will briefly describe
LT, conventional measures and their effectiveness and finally unconventional
measures and their costs and benefits with reference to UK economy. Fiscal policy
will not be discussed in details as the discussion in this paper revolves around
monetary policy.

I shall begin by examining negative demand shocks, a sudden decrease in aggregate

demand for goods and services, which may result in a recession or a period of
sustained negative economic growth. Classical economists argued that interest rate
and money wages will adjust to offset the shock (Froyen 2009). Keynes, when faced
with a negative demand shock, identifies two major problems to ensue if the state
does not intervene 1) Interest insensitive investment demand in the goods market
and 2) Liquidity trap in the money market and therefore favours some sort of
government intervention through monetary and fiscal policies to regulate demand
(Keynes 1936).

Keynes believed that demand plays a crucial role in income determination. He also
believed that money affects income via the interest rate i.e. increase in supply of
money lowers interest rate, lower interest rate increases aggregate demand and
income. Keynes considered three motives for holding money, 1) Transaction
Demand, 2) Precautionary Demand and 3) Speculative Demand (Keynes 1936).

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Liquidity Trap (LT), as described by Keynes, is a situation where at a very low
interest rate demand for money becomes infinitely elastic i.e. speculative demand for
money schedule becomes nearly horizontal and bonds and money become perfect
substitutes. Therefore, even an increase in the money supply may also fail to
increase spending because interest rates can't fall further (Figure 1). (Froyen 2009).
It occurs when investors, banks and consumers are pessimistic about the future.
This uncertainty about future results in some expectations and problems to rise i.e.
expectation of deflation, preference for saving, credit crunch and unwillingness to
hold bonds and has deteriorating consequences for the economy (Krugman P. 2000).
Consequently, in real terms, falling price level will raise the real supply of money,
interest rate will be pushed down to minimum and any further fall in prices will not
stimulate the economy AD curve becomes vertical and the economy enters LT
(Figure 1a).

In normal times governments have monetary and fiscal policy at their disposal to
respond to demand driven economic shock. Fiscal policy which involves altering the
tax regime and government spending are not much effective if the economy has
entered an LT. As noted above fiscal measures were adopted by reducing VAT from
17.5% to 15% in the UK in early 2009 (BoE 2009), however, later on it was realised
that those measure were not sufficient, thus the government turned to monetary
policy. In the rest of this paper I will focus on conventional and non-conventional
monetary policy.

Starting with the conventional monetary policy, i.e. (1) setting a target for overnight
interest rate in the interbank money market and (2) adjusting the supply of central
bank money to that target through open market operations, in normal times then
moving on to unconventional measures such as Quantitative Easing (QE) and Credit
Easing (CE) for abnormal times, i.e. when LT has occurred (ECB 2009).

First the interest rate: Changing the level of key interest rate enables central banks
(CB) to effectively manage liquidity condition in the money market and pursue its
objective of mainlining price stability over the medium term. This has proved to be a
reliable way of providing monetary stimulus to the economy during downturns,
containing inflationary pressures during upturns and in general ensure sound
functioning of the money markets (ECB 2009). In the classical system the quantity
of money determines the price level and the level of nominal income thus it is
important, however it is not given much importance as it does not affect the

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equilibrium values of the real variables such as output, employment and interest rate.
Classical theory of interest rate, in real terms, is illustrated in Figure 2 (Froyen 2009).

Keynes believed that quantity of money played a key role in interest rate and income
determination. Within the IS-LM model, monetary policy affects income by lowering
interest rate and stimulating investment. Assuming a steep IS curve i.e. when
investment is interest-inelastic, changes in interest rate will have a minimal effect on
investment, and thus monetary policy will be ineffective (Figure 3a). It will be more
effective with a flatter IS curve where the interest sensitivity of investment is greater
(Figure 3b). However, in extreme cases where interest elasticity equals zero i.e. IS
curve is vertical; investment will not be affected by monetary policy because it does
not depend on interest rate (Figure 3c) (Froyen 2009).

Secondly supply of money: In the classical system money was regarded only as
the medium of exchange facilitating transactions and determined the price level.
Therefore they did not believe in liquidity trap as a reality. The quantity theory of
money, starting with the equation of exchange presented by Irving Fisher, in the
classical model determines aggregate demand and price level (Figure 4) i.e.
increase in money supply shifts AD curve to the right and the price level rises also,
however output does not change due to its supply determined nature (Froyen 2009).
From a Keynesian view point the monetary expansion will result in a fall in the
interest rate making the private sector activity more attractive. At the new equilibrium,
real GDP will be higher, reflecting higher investment and interest-sensitive
consumption (PSE 2009). Assuming prices are flexible, an increase in the money
supply shifts the LM schedule to the right putting upward pressure on prices and as a
result AD shifts to the right (Figure 5).

However, these conventional methods are effective in normal times but in “abnormal
time” they lose effectiveness. Therefore, unconventional measures are needed for
two general reasons. First, at times when the economic shock is so powerful that the
nominal interest rate needs to be brought down to zero and no more reduction in the
rate is possible. Second, even at times when the nominal interest rate is above zero
but the monetary policy transmission process is significantly impaired. Whenever the
transmission channels of monetary policy is severely impaired conventional monetary
policy actions are largely ineffective. Under these circumstances CBs have to act
directly on the transmission process by using non-conventional measures. In
general, unconventional measures can be defined as those policies that directly

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target the cost and availability of external finance to banks, households and non-
financial companies (ECB 2009).

CBs can implement non-conventional measures in many different ways i.e. (i) by
guiding medium to long-term interest rate expectations, (ii) by changing the
composition of the central bank’s balance sheet, and (iii) by expanding the size of the
central bank’s balance sheet known as Quantitative Easing (QE) and Credit Easing
(CE). All of these measures have one element in common: they are designed to
improve financing conditions beyond the very short-term interbank interest rates
(Bernanke & Reinhart 2004).

Bank of England (BoE) Monetary Policy Committee (MPC) has implemented QE,
which Mervyn King the governor of BoE has also termed as “Conventional
Unconventional monetary policy”, by purchasing asset financed by new money they
have created electronically. The aim of MPC is to inject money directly to the
economy. Most of the assets purchased are government bonds. When BoE buys
the assets, this increases their price and reduces their yields therefore the return on
those assets falls. This will in turn encourage the sellers of those assets to switch to
other financial asset like company shares and bonds. BoE also purchases smaller
amounts of private debt like corporate bonds, aimed at improving conditions in capital
market making it easier for companies to raise money to invest in their businesses
(King 2009).

There is another possibility that BoE’s purchase of assets could put more money into
the economy. Those firms selling assets to BoE deposit more money into their bank
accounts therefore commercial banks have more money to finance new loans, which
can support spending and investment. However this channel appears to be relatively
weak as banks are trying to improve their finance in the wake of the recent crisis.
For this reason BoE purchases assets from firms other than banks. (BoE 2009).

However, there are risks involved with creation of new money. First BoE may lose
money on its purchases of asset and this will put a burden on the taxpayer in the
future either to underwrite this new money with higher taxes or the bank to create
more money to finance the deficit, thus running the risk of higher inflation. Second,
an aggressive creation and spending of money poses the threat of currency
devaluation and inflation and even hyperinflation will ensue. Third, QE can be
counterproductive if it destroys confidence in an economy if business and consumers
feel that the government has lost control of the situation. Fourth, if QE is not

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implemented aggressively enough it may not work to change other interest rates in
the economy and stimulate demand. Finally due to the unorthodox nature of the
policy and complexity of the situation it is difficult to measure how much QE is
needed and how much QE would be too much (FT 2009).

Credit Easing (CE), termed “Uncoventioal Unconventional monetary plicy” by Mervyn

King, is not much different to the QE as it also focuses on expanding CB’s balance
sheet. In contrast to Quantitative Easing, which Bernanke explains focuses on the
liabilities portion of the central bank’s balance sheet; CE focuses on expanding the
asset side of the balance sheet. However since the balance sheet is suppose to
balance; this may just be a difference of terminology since both efforts ultimately add
liquidity into the financial system. Here Bernanke, wants to draw a distinction
between their current policies and the Bank of Japan’s policies between 2001 and
2006 (Bernanke 2009)

Therefore, in conclusion the argument is that conventional monetary policy works

effectively in normal time with shallow recession and healthy transmission channels
of monetary policy. However, in times of deep recessions where a liquidity trap has
taken hold, loss of confidence prevails in the economy among the consumers and
businesses, banks are unwilling to lend, investors are hoarding cash, people expect
deflation, and furthermore the transmission channels of monetary policy is severely
affected conventional measure lose effectiveness and market will not be able to
correct these problem on its on. Therefore, unconventional monetary and fiscal
policy needs to be adopted to respond to the situation and stimulate AD. Thus, the
classical argument that interest rates and money wages will adjust to increase AD,
seems not valid under such circumstances. Keynes arguments that that
governments need to intervene directly, seems more plausible. Recent chain of
events with the banks failures and huge stimulus packages designed by the
governments to boost the economy proves that government needs to tighten
regulatory policies and supervise the financial system more rigorously.

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 Figure 1: Liquidity Trap

Interest Rate
a. The Money Market
r d d Md(Y3) Source: Froyen 2009
M (Y0) M (Y1)
d
M (Y2) Ms0

r3

r2

r1
r0

M
Quantity of Money
Interest Rate

Part a: At very low level of inco

b. The LM Schedule such as Y0 and Y1, equilibrium in
money market occurs at points
r along the flat portion of the mone
demand schedule where the
r3 elasticity of money demand is
extremely high.
r2 Part b: LM schedule is nearly
horizontal over the range Y0 to Y
r1 At higher income levels i.e. Y2 a
Y3 money market equilibrium is
r0 steeper points along the money
demand schedule Md (Y2), Md(Y3
Y0 Y1 Y2 Y3 Y
and the LM schedule becomes
Icome steeper

Figure 1a: Liquidity Trap, Real Analysis.

Page 6 of 11
Source: Lecture Notes (lecture
12) Slater G.
Figure 2: Interest Rate Determination in the Classical System

Interest Rate

r S = SupplyIof
+ loanable funds for
(G-T) = Demand
G-T loanable funds
r1 L F I
B M
0

r0 E

S, I, G - T
I1 S0= I0 S1 = I + (G-T)
Loanable Funds
r0 equates supply of loanable funds which consist of savings
(S), with demand for loanable funds which consist of (I) +
Source: bond financed government deficit (G-T)
Froyen (2009)

Figure 3: Effects on Monetary Policy on the Slope of IS schedule

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A: r LM0 B: r LM1
Steep IS LM1 Flat IS
Schedule Schedule
r0 r0
r1
r1
IS0

IS0

Y0 Y1 Y Y
Y0 Y 1
LM0
C: IS0
r In part a monetary policy is ineffective
Vertical IS LM1
Schedule as investment is assumed to be interest
r0 insensitive. In part b it is effective due
to the greater interest sensitivity of
r1 investment. In part c where IS schedule
is vertical investment is completely
insensitive to changes in the interest rate
(interest elasticity equals zero).
Therefore changes in money supply will
Y0 = Y1 Y be ineffective in stimulating the
economy. Source: Froyen 2009

Figure 4:

Aggregate Demand and Supply in Classical System

Page 8 of 11
 Aggregate Price Level

P Ys1

P3

Yd (M3)
P2
Yd (M2)
P1 Yd (M1)

Y1 = Y2 = Y3 Y
Output
Increases in money supply from M1 to M2 and M3 Shifts AD to the
right from Yd (M1) to Yd (M2) to Yd (M3). The price level rises from
P1 to P2 to P3. Supply determined output is unchanged. (Y1 = Y2 =
Y3).
Source: Froyen 2009

Page 9 of 11
Figure 5: Monetary Expansion with Flexible Prices

a. IS-LM Schedule
r M0
LM
P0 M1
LM
P1
M1
LM
P0
r0 A
r1 C
r2
B

IS0

Y0 Y1 Y2 Y

b. Aggregate Supply-Demand Schedule

P Ys

P1
C
P0 B
A
Yd (M1)

Yd (M0)
Y
Y0 Y1 Y2

Part a. Increase in money supply shifts the LM schedule from

LM(M0/P0) to LM(M1/P0) and AD shifts from Yd (M0) to Yd (M1)
this in turn causes output to rise from Y0 to Y1 and the price
level to rise from P0 to P1. The increase in price level shifts
the LM schedule from LM (M1/P0) to LM (M1/P1).

Source: Froyen 2009

Page 10 of 11
References:
Froyen, R. (2009), Macroeconomic Theories and Policies, (9th Edition), Pearson
Education Inc., New Jersey.

Krugman P. (2000), Thinking about Liquidity Trap, Journal of the Japanese and
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http://www.bankofengland.co.uk/monetarypolicy/framework.htm, [accessed 07 Jan
2010]

King M., (2009), Interview with BBC New 24, [online] available from:
http://www.bankofengland.co.uk/monetarypolicy/assetpurchases_stream.htm,
[accessed on 08 Jan 2010]

Bank of England (2009), Quantitative Easing: How it works, Educational video,

[online] available from:
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2010]

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2010]

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nclick_check=1 [accessed 10 Jan 2010]

Bernanke, B. & Reinhart V. (2004), Conducting Monetary Policy at very low Short-
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Bernanke, B. (2009), Speech: The Crisis and the Policy Response, [online] available
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Keynes J. M, (1936), The General Theory of Employment, Interest and Money

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http://www.marxists.org/reference/subject/economics/keynes/general-theory/
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