How to Escape the Trap of the Current Financial System?

What Is a Liquidity Trap?

A liquidity trap is an economic situation in which asset values are low and savings are extremely high, making monetary policy ineffective. During a liquidity trap, as characterized by economist John Maynard Keynes, consumers often try to avoid bonds and keep their assets in cash savings due to the widespread belief that interest rates will shortly rise (which would push bond prices down). Many investors are hesitant to hold an asset whose value is expected to drop since bonds have an inverse correlation with interest rates. At the same time, central banks’ efforts to boost economic activity are hampered by their inability to decrease interest rates further to entice investors and consumers.

When the ability to enforce monetary actions to enhance demand has diminished because the nominal interest rate has approached an impenetrable limit, the economy is said to be in a liquidity trap. The hypothesis that the purchasing power becomes exponentially delicate to the present value of saving capital is being used to treat liquidity traps.

Causes and Consequences of a Liquidity Trap and Deflation

A growing number of financial institutions are seeking to keep inflation low while maintaining output levels close to capacity. Monetary policy, on the other hand, is made in the face of significant and inevitable uncertainty about the state of the economy, as well as the size and lag of the economy’s response to monetary policy actions. Unprecedented supply and demand shocks are unavoidable. Due to the lags in the effects of monetary policy, good central banks are forward-looking, developing inflation and output forecasts using known economic data and predicted shocks, and sticking as closely as possible to these forecasts.

A significant realized or anticipated negative shock to aggregate demand as a result of the following factors:

  • the bursting of an asset-price bubble,
  • a correction of overly optimistic growth,
  • productivity expectations,
  • increased doubts about future pensions, 
  • benefits due to demographic changes, 
  • potentially reckless fiscal policy, 
  • increased geopolitical uncertainty

will lower both actual inflation and output as well as forecasts of future inflation and output.  If initial inflation is low, this may be all that is needed for not only a temporary recession but a temporary deflation.

Extending liquidity (the monetary base) beyond the satiation point has no effect when this “liquidity trap” happens. The economy may plunge further into a prolonged recession and deflation if a combination of a liquidity trap and deflation leads the real interest rate to remain too high.

Prolonged deflation can have serious negative implications, such as 

  • Increasing the actual value of nominal debt, which can lead to indebted enterprises and families filing for bankruptcy and a drop in asset prices.
  • When collateral loses value and loans default, commercial banks’ balance sheets worsen.
  • Inflationary pressures could pose a problem.
  • Unemployment could increase.
  • If nominal wages are fixed downwards, deflation means that real wages do not decrease but rise, causing unemployment to rise even higher.

All of this might lead to a further drop in aggregate demand, an increase in deflation, an increase in the real interest rate, and a deflationary spiral in which prices and the economy plummet.

A liquidity trap, with the prospect of a prolonged recession or perhaps a deflationary spiral, is therefore a central banker’s worst nightmare.

Escaping from a Liquidity Trap and Deflation

Many academics and policymakers have recently debated the implications of the zero bound, a liquidity trap, and deflation, as well as how to prevent becoming stuck and how to escape if trapped.

  • Targeting inflation

To provide an adequate margin of deflation, many articles suggest an explicit positive symmetric inflation aim. Many central banks already practice forward-looking inflation targeting, attempting to take proactive measures if inflation expectations are too low or too high in comparison to the inflation target. 

  • Price-level targeting

Another option is to define a target path for the price level in the future, such as rising at 2% per year, albeit no central bank presently uses explicit price-level targeting, which is different from price-level targeting. An upward-sloping objective path for the price level should be announced. When it comes to getting out of a liquidity bind.

Because long-term inflation expectations matter more than short-term inflation expectations, a price-level objective has an advantage over an inflation target. If credible, a price-level target has the advantage of correlating to more desired long-term inflation expectations as well as the closing of a pricing gap.

An announcement of inflation or price-level target will lower the real interest rate and be expansionary only to the degree that the targets are credible in the private sector.

  • Expanding the Monetary Base

Only if a rise in the monetary base is viewed as a permanent expansion would it raise inflation expectations and lower the real interest rate. future monetary expansion that is beneficial in terms of the higher future money supply. In theory, the central bank could keep expanding the monetary base indefinitely by buying domestic and foreign government debt, and then other domestic and foreign assets if those were exhausted. Such a drastic strategy would inevitably affect private-sector expectations, have a significant impact on domestic pricing levels and the exchange rate, and put a stop to deflation.

  • Reducing Long Interest Rates

Longer real interest rates, not shorter real interest rates, influence consumption, and investment decisions. As a result, lowering long nominal interest rates might, all else being equal, lower long real rates, which would be expansionary and help the economy escape the liquidity trap.

  • A Tax on Money

Negative nominal interest rates would be able to maintain equilibrium under such a tax, allowing the central bank to reach the desired stimulating negative interest rate. One may also expect public outrage at a system that makes some of the money in people’s pockets appear to be worthless.

As a result, the Foolproof Way entails stating and adopting three measures:

  1. A price-level target path with an upward slant that begins above the current price level and ends with a price gap to close;
  2. A currency devaluation and a currency peg that is creeping;
  3. When the price-level goal path has been reached, an exit strategy in the form of abandoning the peg in favor of inflation or price-level targeting is implemented.

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