Free AIOU Solved Assignment Code 802 Spring 2021

Free AIOU Solved Assignment Code 802 Spring 2021

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Course: Introduction to Macroeconomics (802)
Semester: Spring, 2021
ASSIGNMENT No. 1

Q.1   Discuss the different macroeconomics variables and their relationships.

There are 4 main macroeconomic variables that policymakers should try and manage: Balance of Payments, Inflation, Economic Growth and Unemployment.

This can be easily remembered using the following acronym:

B: Balance of Payments

I: Inflation

G: (Economic) Growth

E: Employment

The Balance of Payments is the difference between the total amount of goods a country exports (sells to other countries) and the total amount of goods a country imports (buys from other countries). This can be simplified to X-M. If the amount of goods that a country exports (X) is greater than the amount of goods that a country imports (M), there is a balance of payments surplus because X>M. If the amount of goods that a country exports (X) is less than the amount of goods that a country imports (M), there is a balance of payments deficit because X.

Inflation is the amount that the cost of goods and services within an economy has increased over a given time period (usually measured over a year). In the UK, this is measured using the Consumer Price Index (CPI). Inflation is damaging to an economy and this means that policymakers tend to try and keep inflation low. For example, the Bank of England aim to set inflation at around 2%. There are 2 types of inflation, cost-push inflation (which is caused by the costs of production for firms increasing, forcing them to put their sale prices up) and demand-pull inflation (which is caused by growing demand for goods that firms produce, allowing firms to increase prices to gain more profit).

Economic growth is the amount that the level of output within an economy increases over a given time period (again usually measured over a year). Economic growth is extremely desirable as it means that, in general, the people within an economy are getting richer. Economic growth can be increased in a number of ways, such as technological improvement, an increase in the demand for goods and services, and an increase in the size of the workforce (a fall in unemployment).

Unemployment is the amount of people within an economy who are willing and able to work, but do not have a job. There are a number of different types of unemployment. Frictional unemployment (which is unemployment caused by the search for a new job or a transition between jobs), structural unemployment (caused by the decline of an industry, for example type-writing or coal mining), seasonal unemployment (caused by the time of year, for example working on a Christmas tree farm is undesirable during summer), and cyclical unemployment (which is caused by a recession – a reduction in the level of output within an economy). Macroeconomics is the study of the economy as a whole. Understanding macroeconomics requires understanding its terms. Because macroeconomic systems are complex, economists build models to represent the interactions of the important components of the economy. These models depend on key macroeconomic variables with the greatest influence on the economy.

  • the study of the economy as a whole, and the variables that control the macro-economy.
  • the study of government policy meant to control and stabilize the economy over time, that is, to reduce fluctuations in the economy.
  • the study of monetary policy, fiscal policy, and supply-side economics.
  • the major variables describing the macro-economy are the same.
  • the three major policy approaches are the same
  • but the quality to which these policies are applied differ from one country to another; this because the political process from which these policies emerge are unique to each country.
  • First, microeconomics studies individual components, whereas macroeconomics studies the economy as a whole.
  • microeconomics treats the economy as so many separate components, whereas macroeconomics treats the components of the economy as one unit, as one aggregate, that is looks for relationships between the various components.
  • Second, controversy aside, government involvement in microeconomics is relatively small, and relegated to public goods, regulation, and welfare.
  • But, controversy notwithstanding, government involvement in macroeconomics is rather substantial, nearly total; it is only government that makes and enforces monetary and fiscal policy.
  • Third, whereas microeconomics has been around since the mid eighteenth century, macroeconomics began only as a reaction to the Great Depression of the 1930s.

Macroeconomics uses many terms that are common words, but have more specific meanings in macroeconomics, such as investment and capital. Macroeconomics is also studied through econometric models, which depend on key macroeconomic variables. The term investment is also used differently in economics. Most people use the term as the investment of money, such as buying stocks or bonds. However, buying financial instruments is not considered an investment in the economic sense, since it does not buy capital. When a firm receives an investment of money, it may use that money to buy new capital, but the initial purchase of the financial instrument is not considered an investment, since that money could also be used to buy used equipment, for instance. In economics, the term investment means buying new capital to produce goods and services. Note the term new. Buying used capital, such as a used car or factory equipment, is not an economic investment, since the capital stock of the economy has not increased because of the investment. A firm may consider itself to be investing when buying used equipment, since such equipment can often be purchased at a much lower price than new equipment, but since it does not increase the overall capital stock of the economy, it is not considered an economic investment. This is true because one’s expense is another’s income. Because all countries have some foreign trade, the aggregate income will differ from the aggregate expenditure, and both will differ from Gross Domestic Product (GDP). If aggregate income is greater, then the economy is running a trading surplus; if aggregate expenditure is greater, then the economy is running a trading deficit. Economics also distinguishes between a flow variable and a stock variable. A flow variable is specified as a quantity per unit of time; a stock variable is a specific quantity at a specified time. Some examples:

  1. Income is a flow variable, since it represents the amount of money received for a duration. Wealth is a stock variable, representing the amount of wealth that one has at some point in time.
  2. Annual debt payments is considered a flow variable, while the total debtis a stock variable.
  3. Changes in the unemployment rate is a flow variable, while total unemploymentis a stock variable.

Economists also distinguish between nominal variables and real variables. Nominal variables are quoted in terms of money, but because inflation changes the value of money every year, a nominal variable cannot easily be compared from year to year unless the inflation is accounted for.

AIOU Solved Assignment Code 802 Spring 2021

Q.2   Explain the following concepts with examples.                                            

  1. Average Propensity to consume (APC)

The average propensity to consume can be referred to as the percentage of income spent on goods and services by an individual. It is arrived at by dividing the total amount spent on household consumption by the total disposable income. An increase in the average propensity to consume denotes a high demand for goods and services. An increase or decrease in the average propensity to consume also determines the propensity to save. The opposite of the average propensity to consume is the average propensity to save.

A tendency of incremental savings has a negative effect on the average propensity to consume. High-income households have a less average propensity to save. However, in the case of a fresh earner, an increase in income has an incremental effect on the average propensity to consume.

Low-income families have a higher propensity to consume. They tend to spend most of their monthly earnings on essential goods and services.

The average propensity to consume and the savings ratio are expressed as a percentage of the total disposable income.

Consumer spending helps in boosting the economy. When there is a high demand for the supply of goods, more goods are purchased, more people are employed, and more business are open.

When people have a tendency to save, it can negatively affect the economy as people purchase fewer goods and services. It indicates that there is a low demand for goods and services, resulting in fewer jobs, and increased business closures.

Ideally, the sum of the average propensity to consume and the average propensity to save is equivalent to one. This is due to the fact that households use all income for either saving or consumption.

Contrary to the average propensity to consume, the APS is calculated as the percentage of total income used for saving rather than spending on goods and services. The average propensity to consume could also be calculated by subtracting the APS from 1.

The APS is also known as the savings ratio, and it is usually expressed as a percentage of total household disposable income (income minus taxes).

  1. Marginal Propensity to Consume (MPS)

In economics, the marginal propensity to consume (MPC) is defined as the proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services, as opposed to saving it. Marginal propensity to consume is a component of Keynesian macroeconomic theory and is calculated as the change in consumption divided by the change in income. MPC is depicted by a consumption line, which is a sloped line created by plotting the change in consumption on the vertical “y” axis and the change in income on the horizontal “x” axis.

  • Marginal Propensity to Consume is the proportion of an increase in income that gets spent on consumption.
  • MPC varies by income level. MPC is typically lower at higher incomes.
  • MPC is the key determinant of the Keynesian multiplier, which describes the effect of increased investment or government spending as an economic stimulus.

Given data on household income and household spending, economists can calculate households’ MPC by income level. This calculation is important because MPC is not constant; it varies by income level. Typically, the higher the income, the lower the MPC because as income increases more of a person’s wants and needs become satisfied; as a result, they save more instead. At low-income levels, MPC tends to be much higher as most or all of the person’s income must be devoted to subsistence consumption.

According to Keynesian theory, an increase in investment or government spending increases consumers’ income, and they will then spend more. If we know what their marginal propensity to consume is, then we can calculate how much an increase in production will affect spending. This additional spending will generate additional production, creating a continuous cycle via a process known as the Keynesian multiplier. The larger the proportion of the additional income that gets devoted to spending rather than saving, the greater the effect. The higher the MPC, the higher the multiplier—the more the increase in consumption from the increase in investment; so, if economists can estimate the MPC, then they can use it to estimate the total impact of a prospective increase in incomes.

To calculate the marginal propensity to consume, the change in consumption is divided by the change in income. For instance, if a person’s spending increases 90% more for each new dollar of earnings, it would be expressed as 0.9/1 = 0.9. On the other hand, consider a person receives a bonus of $1,000 and spends $100 of this while saving $900. The marginal propensity to consume would equal $100/$1,000 or 0.1.

  • The Multiplier

In economics, a multiplier broadly refers to an economic factor that, when increased or changed, causes increases or changes in many other related economic variables. In terms of gross domestic product, the multiplier effect causes gains in total output to be greater than the change in spending that caused it. The term multiplier is usually used in reference to the relationship between government spending and total national income. Multipliers are also used in explaining fractional reserve banking, known as the deposit multiplier.

  • A multiplier refers to an economic factor that, when applied, amplifies the effect of some other outcome.
  • A multiplier value of 2x would therefore have the result of doubling some effect; 3x would triple it.
  • Many examples of multipliers exist, such as the use of margin in trading or the money multiplier in fractional reserve banking.

A multiplier is simply a factor that amplifies or increase the base value of something else. A multiplier of 2x, for instance, would double the base figure. A multiplier of 0.5x, on the other hand, would actually reduce the base figure by half. Many different multipliers exist in finance and economics.

The Fiscal Multiplier

The fiscal multiplier is the ratio of a country’s additional national income to the initial boost in spending or reduction in taxes that led to that extra income. For example, say that a national government enacts a $1 billion fiscal stimulus and that its consumers’ marginal propensity to consume (MPC) is 0.75. Consumers who receive the initial $1 billion will save $250 million and spend $750 million, effectively initiating another, smaller round of stimulus. The recipients of that $750 million will spend $562.5 million, and so on.

The Investment Multiplier

An investment multiplier similarly refers to the concept that any increase in public or private investment has a more than proportionate positive impact on aggregate income and the general economy. The multiplier attempts to quantify the additional effects of a policy beyond those immediately measurable. The larger an investment’s multiplier, the more efficient it is at creating and distributing wealth throughout an economy.

The Earnings Multiplier

The earnings multiplier frames a company’s current stock price in terms of the company’s earnings per share (EPS) of stock. It presents the stock’s market value as a function of the company’s earnings and is computed as (price per share/earnings per share).

This is also known as the price-to-earnings (P/E) ratio. It can be used as a simplified valuation tool for comparing relative costliness of the stocks of similar companies, and for judging current stock prices against their historical prices on an earnings relative basis.

The Equity Multiplier

The equity multiplier is a commonly used financial ratio calculated by dividing a company’s total asset value by total net equity. It is a measure of financial leverage. Companies finance their operations with equity or debt, so a higher equity multiplier indicates that a larger portion of asset financing is attributed to debt. The equity multiplier is thus a variation of the debt ratio, in which the definition of debt financing includes all liabilities.

AIOU Solved Assignment 1 Code 802 Spring 2021

Q.3   Explain how to derive an aggregate supply curve, assuming that money wages are:

  1. Flexible

In economics, aggregate supply is the total supply of goods and services that firms in a national economy plan to sell during a specific time period. It is the total amount of goods and services that the firms are willing to sell at a given price level in the economy. Aggregate supply is the relationship between the price level and the production of the economy. In the short-run, the aggregate supply is graphed as an upward sloping curve. The equation used to determine the short-run aggregate supply is: Y = Y* + α(P-Pe). In the equation, Y is the production of the economy, Y* is the natural level of production of the economy, the coefficient α is always greater than 0, P is the price level, and Pe is the expected price level from consumers.

The short-run aggregate supply curve is upward sloping because the quantity supplied increases when the price rises. In the short-run, firms have one fixed factor of production (usually capital ). When the curve shifts outward the output and real GDP increase at a given price. As a result, there is a positive correlation between the price level and output, which is shown on the short-run aggregate supply curve.

In the long-run, the aggregate supply is graphed vertically on the supply curve. The equation used to determine the long-run aggregate supply is: Y = Y*. In the equation, Y is the production of the economy and Y* is the natural level of production of the economy.

The long-run aggregate supply curve is vertical which reflects economists’ beliefs that changes in the aggregate demand only temporarily change the economy’s total output. In the long-run, only capital, labor, and technology affect aggregate supply because everything in the economy is assumed to be used optimally. The long-run aggregate supply curve is static because it is the slowest aggregate supply curve. a curve that shows the relationship between price level and real GDP that would be supplied if all prices, including nominal wages, were fully flexible; price can change along the LRAS, but output cannot because that output reflects the full employment output.

  1. Rigid

In macroeconomics, we seek to understand two types of equilibria, one corresponding to the short run and the other corresponding to the long run. The short run in macroeconomic analysis is a period in which wages and some other prices do not respond to changes in economic conditions. In certain markets, as economic conditions change, prices (including wages) may not adjust quickly enough to maintain equilibrium in these markets. A sticky price is a price that is slow to adjust to its equilibrium level, creating sustained periods of shortage or surplus. Wage and price stickiness prevent the economy from achieving its natural level of employment and its potential output. In contrast, the long run in macroeconomic analysis is a period in which wages and prices are flexible. In the long run, employment will move to its natural level and real GDP to potential. We begin with a discussion of long-run macroeconomic equilibrium, because this type of equilibrium allows us to see the macroeconomy after full market adjustment has been achieved. In contrast, in the short run, price or wage stickiness is an obstacle to full adjustment. Why these deviations from the potential level of output occur and what the implications are for the macroeconomy will be discussed in the section on short-run macroeconomic equilibrium.

Wage or price stickiness means that the economy may not always be operating at potential. Rather, the economy may operate either above or below potential output in the short run. Correspondingly, the overall unemployment rate will be below or above the natural level.

Many prices observed throughout the economy do adjust quickly to changes in market conditions so that equilibrium, once lost, is quickly regained. Prices for fresh food and shares of common stock are two such examples.

Other prices, though, adjust more slowly. Nominal wages, the price of labor, adjust very slowly. We will first look at why nominal wages are sticky, due to their association with the unemployment rate, a variable of great interest in macroeconomics, and then at other prices that may be sticky.

Wage contracts fix nominal wages for the life of the contract. The length of wage contracts varies from one week or one month for temporary employees, to one year (teachers and professors often have such contracts), to three years (for most union workers employed under major collective bargaining agreements). The existence of such explicit contracts means that both workers and firms accept some wage at the time of negotiating, even though economic conditions could change while the agreement is still in force.

Think about your own job or a job you once had. Chances are you go to work each day knowing what your wage will be. Your wage does not fluctuate from one day to the next with changes in demand or supply. You may have a formal contract with your employer that specifies what your wage will be over some period. Or you may have an informal understanding that sets your wage. Whatever the nature of your agreement, your wage is “stuck” over the period of the agreement. Your wage is an example of a sticky price.

One reason workers and firms may be willing to accept long-term nominal wage contracts is that negotiating a contract is a costly process. Both parties must keep themselves adequately informed about market conditions. Where unions are involved, wage negotiations raise the possibility of a labor strike, an eventuality that firms may prepare for by accumulating additional inventories, also a costly process. Even when unions are not involved, time and energy spent discussing wages takes away from time and energy spent producing goods and services. In addition, workers may simply prefer knowing that their nominal wage will be fixed for some period of time.

  1. Rigid downward and flexible upward

The sticky wage theory hypothesizes that employee pay tends to respond slowly to changes in company performance or to the economy. According to the theory, when unemployment rises, the wages of those workers that remain employed tend to stay the same or grow at a slower rate rather than falling with the decrease in demand for labor. Specifically, wages are often said to be sticky-down, meaning that they can move up easily but move down only with difficulty.

  • Sticky wage theory argues that employee pay is resistant to decline even under deteriorating economic conditions.
  • This is because workers will fight against a reduction in pay, and so a firm will seek to reduce costs elsewhere, including via layoffs, if profitability falls.
  • Because wages tend to be “sticky-down”, real wages are instead eroded through the effects of inflation.
  • A key piece of Keynesian economic theory, “stickiness” has been seen in other areas as well such as in certain prices and taxation levels.

Stickiness is a theoretical market condition wherein some nominal price resists change. While it often apply to wages, stickiness may also often be used in reference to prices within a market, which is also often called price stickiness.

The aggregate price level, or average level of prices within a market, can become sticky due to an asymmetry between the rigidity and flexibility in pricing. This asymmetry often means that prices will respond to factors that allow them to go up, but will resist those forces acting to push them down. This means that levels will not respond quickly to large negative shifts in the economy as they otherwise would. Wages are often said to work in the same way: people are happy to get a raise, but will fight against a reduction in pay.

Wage stickiness is a popular theory accepted by many economists, although some purist neoclassical economists doubt its robustness. Proponents of the theory have posed a number of reasons as to why wages are sticky. These include the idea that workers are much more willing to accept pay raises than cuts, that some workers are union members with long-term contracts or collective bargaining power, and that a company may not want to expose itself to the bad press or negative image associated with wage cuts.

Stickiness is an important concept in macroeconomics, particularly so in Keynesian macroeconomics and New Keynesian economics. Without stickiness, wages would always adjust in more or less real-time with the market and bring about relatively constant economic equilibrium. With a disruption in the market would come proportionate wage reductions without much job loss. Instead, due to stickiness, in the event of a disruption, wages are more likely to remain where they are and, instead, firms are more likely to trim employment. This tendency of stickiness may explain why markets are slow to reach equilibrium, if ever.

AIOU Solved Assignment 2 Code 802 Spring 2021

Q.4   Explain the process of deposit expansion and deposit contraction in detail.

Expansion of deposits is the process in which banks create additional money by using money already deposited. The money expands because when banks loan it out, it reenters the economy. In fact, most of the money supply in the United States is created in this fashion.

Before being loaned out, deposits in a bank do not increase the overall money supply. The funds deposited merely change in composition from currency to deposit. Money is created only when funds that have been deposited are loaned out. Because banks are required to hold a fraction of deposits in reserve, only the remaining fraction, when lent out, increases the money supply. The fraction lent out is a multiple of the fraction that must be held in reserve. The mathematical function that describes the maximum possible expansion of deposits is known as the money multiplier. The money multiplier is the amount of money generated by the banking system with each dollar of reserves. It shows the total amount of money created by the system. The money multiplier is calculated with this equation:

\text{Money Multiplier}=\frac{1}{\text{Required Reserve Ratio}}Money Multiplier=Required Reserve Ratio1

The required reserve ratio (RR) is the percentage of deposits a bank is required to hold in reserve and not lend out or invest. For example, if a bank is required to reserve $1 for every $4 deposited, the required reserve ratio is 25%, or 0.25. The equation for arriving at the money multiplier would be 1/0.25=41/0.25=4. Therefore, when the required reserve ratio is 0.25, the money multiplier is equal to 4.

The fraction of a deposit that a bank can loan out or invest is called excess reserves. It is through its excess reserves that a bank can grow its total reserves. For example, if a bank has $1 million in deposits and the required reserve ratio is 10%, the excess reserves for the bank is $900,000.

The process of deposit expansion does not end with that first bank loaning out its excess reserves because the borrower is likely to deposit the money in another bank for use in transactions. The second bank can use this deposit to expand the money supply again. For example, if an initial deposit made with Bank 1 is $100,000 and the required reserve ratio is 10%, the bank must hold 10% of $100,000 (or $10,000) in required reserves. This means Bank 1 has $90,000 in excess reserves, which it can lend out. If the bank lends out all $90,000 and $90,000 is deposited in Bank 2, which has the same required reserve ratio, then Bank 2 can lend out $81,000 of the deposited sum. If the maximum amount of money is lent out and deposited in Bank 3, this bank can lend out $72,900. In this way, starting from an initial deposit of $100,000, over the course of just three deposits, the money supply could potentially increase by \$90{,}000+\$81{,}000+\$72{,}900=\$243{,}900$90,000+$81,000+$72,900=$243,900. This process continues on, so the total new money created is the value of the money multiplier times the initial deposit. In this example, the total new money created is 1 divided by 0.1, or 10 (money multiplier) times $100,000 (initial deposit), which equals $1,000,000. This continued expansion of the money supply that occurs when money created by fractional reserve banking is redeposited, which creates more money, which can itself be redeposited, and create further economic growth is called the multiple expansion of deposits.

  • Most of the money in the United States today (measured as M1 or M2) is created by banks
  • Banks create money whenever they make loans.  The process is that the bank creates a liability (deposit) to pay for an asset (loan)
  • The definitive factor that allows banks to create deposits/money is our fractional reserve system
  • Whenever cash is deposited into a bank, this leads to an increase in that banks reserves as well as an increase in deposits, but does not increase the money supply—only changes its composition (exchanging deposits for currency)
  • While an individual bank can make loans and create deposits only to the extent (on a dollar-per-dollar basis) that it has excess reserves [Note: total reserves less required reserves equals excess reserves], the banking system can create deposits equal to some multipleof its excess reserves.  The magnitude of that multiple is expressed as the money multiplier.

An economic contraction is a decline in national output as measured by gross domestic product (GDP). That includes a drop in real personal income, industrial production, and retail sales. It increases unemployment rates. Companies stop hiring to save money in the face of lower demand. Toward the middle of a contraction, they start laying off workers, sending unemployment rates higher. It’s one of the four phases of the business cycle, also known as the boom and bust cycle.

The National Bureau of Economic Research uses economic indicators to determine when a contraction has occurred. Since 1854, there have been 34 contractions.1 They typically last 17.5 months each. America’s history of recessions shows that economic contractions are inevitable, albeit painful, parts of the business cycle.

A contraction is caused by a loss in confidence that slows demand. An event, like a stock market correction or crash, triggers it. But the true cause precedes the well-publicized event. It’s typically an increase in interest rates that decrease the capital.

Investors sell stocks, sending prices downward and reducing financing for large corporations. Businesses cut spending, then lay off workers. That dries up consumer spending, which creates further business losses and layoffs. To understand this economic downturn, one has to be aware of the causes of the business cycle, especially the causes of a recession.

A contraction ends when prices fall enough to attract renewed demand. Central bank monetary policy and government fiscal policy can end a contraction more quickly. They will lower interest rates and taxes, and increase the money supply and spending. These policies are integral to a nation’s strategies for supplying the best unemployment solutions.

The Covid-19 pandemic has caused a major contraction in the US economy. As a result, the Business Cycle Dating Committee of the National Bureau of Economic Research determined that, “a peak in monthly economic activity occurred in the U.S. economy in February 2020. The peak marks the end of the expansion that began in June 2009 and the beginning of a recession. The expansion lasted 128 months, the longest in the history of U.S. business cycles dating back to 1854. The previous record was held by the business expansion that lasted for 120 months from March 1991 to March 2001.”

AIOU Solved Assignment Code 802 Autumn 2021

 

Q.5  Define the liquidity trap, if the economy is stuck in one, would your advice the use of monetary or fiscal policy?

Liquidity trap is a situation when expansionary monetary policy (increase in money supply) does not increase the interest rate, income and hence does not stimulate economic growth. Liquidity trap is the extreme effect of monetary policy. It is a situation in which the general public is prepared to hold on to whatever amount of money is supplied, at a given rate of interest. They do so because of the fear of adverse events like deflation, war. In that case, a monetary policy carried out through open market operations has no effect on either the interest rate, or the level of income. In a liquidity trap, the monetary policy is powerless to affect the interest rate. There is a liquidity trap at short term zero percent interest rate. When interest rate is zero, public would not want to hold any bond, since money, which also pays zero percent interest, has the advantage of being usable in transactions. Hence, if the interest is zero, an increase in quantity of money cannot not induce anyone to buy bonds and thereby reduce the interest on bonds below zero.

A liquidity trap is a contradictory economic situation in which interest rates are very low and savings rates are high, rendering monetary policy ineffective. First described by economist John Maynard Keynes, during a liquidity trap, consumers choose to avoid bonds and keep their funds in cash savings because of the prevailing belief that interest rates could soon rise (which would push bond prices down). Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline. At the same time, central bank efforts to spur economic activity are hampered as they are unable to lower interest rates further to incentivize investors and consumers.

  • A liquidity trap is when monetary policy becomes ineffective due to very low interest rates combined with consumers who prefer to save rather than invest in higher-yielding bonds or other investments.
  • While a liquidity trap is a function of economic conditions, it is also psychological since consumers are making a choice to hoard cash instead of choosing higher-paying investments because of a negative economic view.
  • A liquidity trap isn’t limited to bonds. It also affects other areas of the economy, as consumers are spending less on products which means businesses are less likely to hire.
  • Some ways to get out of a liquidity trap include raising interest rates, hoping the situation will regulate itself as prices fall to attractive levels, or increased government spending.

In a liquidity trap, should a country’s reserve bank, like the Federal Reserve in the USA, try to stimulate the economy by increasing the money supply, there would be no effect on interest rates, as people do not need to be encouraged to hold additional cash.

As part of the liquidity trap, consumers continue to hold funds in standard deposit accounts, such as savings and checking accounts, instead of in other investment options, even when the central banking system attempts to stimulate the economy through the injection of additional funds. High consumer savings levels, often spurred by the belief of a negative economic event on the horizon, causes monetary policy to be generally ineffective.

The belief in a future negative event is key, because as consumers hoard cash and sell bonds, this will drive bond prices down and yields up. Despite rising yields, consumers are not interested in buying bonds as bond prices are falling. They prefer instead to hold cash at a lower yield.

A notable issue of a liquidity trap involves financial institutions having problems finding qualified borrowers. This is compounded by the fact that, with interest rates approaching zero, there is little room for additional incentive to attract well-qualified candidates. This lack of borrowers often shows up in other areas as well, where consumers typically borrow money, such as for the purchase of cars or homes.

        

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