Discuss the concept of “liquidity trap” and explain how it can pose challenges for central banks in implementing monetary policy.
The correct answer and explanation is:
A liquidity trap occurs when interest rates are near zero, and monetary policy becomes ineffective at stimulating economic activity. In this scenario, individuals and businesses are unwilling to borrow or spend, even though the central bank is attempting to increase money supply and lower interest rates. Typically, central banks use tools such as lowering interest rates or quantitative easing to boost economic activity, but in a liquidity trap, these measures fail to encourage borrowing or investment because people expect little or no return from borrowing, especially when they anticipate deflation or economic stagnation.
A liquidity trap presents significant challenges for central banks. First, traditional tools like lowering interest rates are no longer effective. When interest rates are already at or near zero, the central bank cannot reduce them further to stimulate demand. Second, with people and businesses holding onto cash instead of spending or investing, even large increases in the money supply might not result in economic growth. Central banks often turn to unconventional tools such as quantitative easing, where they purchase long-term assets to increase the money supply and encourage lending. However, this also has limited effectiveness if the private sector is unwilling to borrow or invest.
Moreover, a liquidity trap can lead to prolonged economic stagnation or deflation, as businesses and consumers expect prices to fall and delay consumption or investment. This can create a vicious cycle of reduced demand, lower production, and further declines in prices. In such situations, central banks may find it difficult to restore confidence and revive economic activity, often requiring the support of fiscal policy measures, such as government spending or tax cuts, to help stimulate the economy. Thus, a liquidity trap limits the scope of monetary policy and makes economic recovery more challenging.