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Liquidity Trap: Definition & Graph

Instructor: Toni Bonton

Toni has taught personal finance and is currently pursuing a doctorate in business administration.

Loaning money to the government through investments can be profitable, but when it is not, it can pose a problem to the government's money supply. This lesson discusses the liquidity trap.

Mo' Money, Mo' Problems

Justin just inherited a large sum of money and is looking to make a few investments. He already has a few government bonds and thinks that may be the route to go. Government bonds are debt securities distributed by the government to add to the amount of money they have available to spend. In other words, when an individual purchases a government bond, they are essentially purchasing an IOU from the government, which allows the government to put more money into circulation. By issuing these bonds, the government can control the increase, decrease, and overall size of their money supply.

Take It to the Bank

Justin heads to the bank to talk to Kevin, his personal banker, about current interest rates. Kevin informs Justin that the current interest rate on government bonds is 0.25%. This means that for every $1000 Justin invests into a government bond, he will only make $13.60 each year. Justin's investment will also be tied up for several years until the bond matures, or when the bond is paid back. That hardly seems worth the investment to Justin and he immediately tells Kevin that he would like to explore other options.

Kevin tells Justin about a money market account paying an annual percentage rate 0.50%. A money market account is a savings accounts that pay higher interest rates because the minimum balance required to open the account is much larger than a regular savings account. Given the current interest rate on the money market, Justin will earn $15 each year for every $1000 he puts into the account and his money remains liquid, meaning readily available.

At this point, Justin has two options. He can tie up his money by loaning it to the government and earning $13.60 each year for every $1000 he decides to invest into bonds or he can have constant access to his money by saving it in an account and earning $15 each year for every $1000 he decides to deposit into the account.

The Trap

Justin's situation indicates a liquidity trap. A liquidity trap is an instance where interest rates are low enough to hinder consumers from investing or lending money to the government and savings rates are high enough to encourage people to save their money, neutralizing the government's control of the money supply. Don't worry if that sounds confusing, here's the lowdown.

A simple way to think of a liquidity trap
liquidity trap

Interest Rate = interest rate of the government bond

Investment Needed = the amount of investment needed to make a profit

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