MACRO ASS

A liquidity trap is an adverse economic situation that can occur when

consumers and investors hoard cash rather than spend or invest it even
when interest rates are low, stymying efforts by policymakers to stimulate
economic growth. A liquidity trap may develop when consumers and
investors keep their cash in checking and savings accounts because they
believe interest rates will soon rise. That would make bond prices fall, and
make them a less attractive option. The belief in a future negative event is
central to understanding liquidity traps. When consumers hoard cash and
sell bonds, this drives bond prices down and yields up. Despite rising
yields, consumers are not interested in buying bonds as bond prices are
falling. Instead, they may prefer to hold cash at a lower yield.

CASE STUDY

Starting in the 1990s, Japan faced a liquidity trap. Interest rates continued
to fall and yet investment did not rebound. The Nikkei 225 which is the
main stock index in Japan fell drastically.

Interest rates were set to 0% by Japan's central bank but investing,

consumption, and inflation all remained subdued for several years
following the height of the crisis.

Japan faced deflation through the 1990s, and in 2022 still had a negative
interest rate of -0.1%. Recently, When the Bank of Japan (BoJ) announced
a new short-term interest rate target in the 0% to 0.1% range last month, it
marked a historic shift in the country's monetary policy. After years of
unconventional monetary easing, the central bank ended negative interest
rates.