The liquidity trap may be defined as the set up of points on the liquidity preference curve where the percentage change in the demand for money, or ΔM/M in response to a percentage in the rate of interest, or Δi/i, approaches infinity.
In other words, there be a liquidity trap when the demand for money becomes perfectly elastic at a particular low rate of interest.
Refer to in which the L 2 curve depicts the liquidity preference under the speculative motive, at varying rates of interest.
It is obvious, from the diagram, that a high interest rate (20%) there is very little demand for money under the speculative motive.
As the interest rate moves lower and lower, the demand for speculative balances becomes larger and larger until at 2% it becomes infinitely elastic, i.e., any increase in the money supply will be held as idle cash, balances by the people.
This situation is called liquidity trap. The trap is depicted in the liquidity preference curve (LP), where the slope of the tangent to the curve becomes horizontal.
The existence of the trap, in real, world, would be characterised by a situation, at a moment in time, when large increases in the money stock would simply be absorbed as speculative idle balances, in anticipation of a future rise in the rate of interest.
The liquidity trap is caused by two reasons:
1. At a very low rate of interest on alternative assets in the financial market, the opportunity cost of holding idle balance tends to be the minimum.
2. When interest rates come down to a minimum, the opportunity cost of hoarding idle money is expected to rise in the future rather than decline further.
As such people are induced to hoard as idle balances all the additional money supply made available at this minimum rate of interest.
This makes the demand for money perfectly elastic. As a result, any additional money supply fails to bring down the rate of interest further.
The liquidity trap is also important, partly, because it is thought to concern situations in which the monetary officials lose control over investment in real capital goods via the rate of interest.
According to Bronfenbrenner and Mayer, the phenomenon called “liquidity trap” is mentioned incidentally in terms of elasticity. It makes little difference whether Keynes defines the liquidity trap in terms of an infinite elasticity or a zero slope of a liquidity function.”
The liquidity trap suggests that any additional money supply is absorbed by the people as idle balances at a particular minimum rate of interest. Here the demand for money tends to be perfectly elastic which prevents the rate of interest from falling further.
It may be concluded then that there are three motives transactions, precautionary and speculative that act as determinants of the demand for money.
The transactions and precautionary demand for money is income determined, more or less interest inelastic and relatively a stable phenomenon, whereas the speculative demand for money is interest-elastic, income-determining and very sensitive and fluctuating.
In the Keynesian view, it is the speculative demand for money that introduces a dynamic element in the process of general price movements and in the volume of employment and output through a relationship between the current and perspective rates of interest and the profitability of investment.
It has been observed, however, that during inflationary conditions in the economy, the transactions demand for money tends to rise.
When prices in general are rising, people find a decreasing value of money, so they may tend to hold more real assets rather than money. Hence their volume of transactions will rise.
Again, in view of the rising prices, their routine expenditure will also rise. As such, during inflation, people will be induced to hold more active balances for transactions purposes, i.e., to spend quickly. During deflation, apparently, the transactions demand for money will tend to decrease.