Saturday, August 10, 2013

Liquidity Trap




During the Great Recession, many central banks reduced their interest rates to historically low levels. However, the interest rate was good to be its zero point, it remained higher than the natural rate, that is to say, the nominal interest rate which closes the output gap and ensure price stability. However, once the zero lower bound is reached, the central bank may further cut its key interest rate, which exposes the economy to deflationary pressures and an increase in its unemployment rate. In such a situation called liquidity trap, where monetary policy is proving excessively restrictive fiscal authorities must necessarily intervene to counteract deflationary pressures. The finance managers adopt their next steps "unconventional" to make them more effective monetary policy. However, the Great Recession is different from previous episodes of liquidity trap, including the lost decade in Japan, that the phenomenon of liquidity trap this time has a global dimension. The United States, UK and the other Euro countries are the countries most closely linked by trade and financial linkages that have experienced the largest slowdown in crisis, bringing their monetary authorities to fix the interest rate to the nearest zero.
According to famous Economist, the appearance of liquidity traps in a context where markets for goods, services and capital are integrated internationally gives a new dimension to the dilemma highlighted by the literature in finance International (also called "impossible trinity" or "impossible trinity"). The traditional interpretation of this phenomenon, a country cannot simultaneously ensure the opening of capital markets, fixed exchange rates and monetary policy autonomy. If achieved two goals, the third becomes unattainable. However, even if the exchange rate is flexible and fully opens capital markets, monetary policy loses its effectiveness in a liquidity trap. If the domestic economy is a powerful external shock depressing domestic demand, the zero lower bound is likely to constrain its own monetary policy. Financial markets play a key role in the spread of the phenomenon of liquidity trap a country to another.

The economic literature have suggested that the introduction of capital controls to reduce the risk that a country will suffer destabilizing capital inflows: inflows are indeed likely to fuel an unsustainable credit expansion, the formation of bubbles assets and excessive currency appreciation, especially in emerging countries. The introduction of capital controls makes monetary policy more effective in reducing the risk that the economy switches into a liquidity trap.

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