A liquidity trap occurs when the 2 levers of monetary fiscal policy, interest rates and open market buying and selling of the federal bonds no longer effect any control over the financial system.
The fed lowers and raises interest rates essentially shrinking the cost of money for the banks who lend, and the borrowers. Note that banks pay a half-penny for a loan of one dollar, but will then turn around and assess 4.5 cents to 19 cents when used as loans and credit card financing.
The fed also buys and sells the federal debt bond paper on the open market in order to influence the amount of money in the monetary supply. Money however can come in countable different forms. Money can be the cash we keep in our wallet, a check that represents an account at a bank, or records of deposit. As opposed to tradeable commodities like securities(bundles of loans) and stocks, money is said to be fixed in the sense that it cannot be used as collateral. For instance, if you have a 100 dollar bill, nothing will change the value from $100. But a stock or bond that is worth $100 today, may be worth more or less numerically.
The purchase power of money does affect the value, but not the numerical amount. Thus an economy consists of 2 different types of measuring net worth.
The use of interest rates affects the costs of borrowing and loaning money but not the supply. Buying and selling government debt adds or subtracts from the liabilities section on the financials. Whereas buying decreases liabilities, selling soaks up "liquidity" but only in the sense of loanable cash because the bonds themselves can be used as collateral, at which point they become an asset. Such is the genious of accountanting.
The liquidity crisis occurs when lower interest rates do not stir business activity. The costs of debts are lessened, but the economic spurt does not workin a situation where companies have high debt burdens, and when there is a supply glut.
In a global economy, with financial markets able to quickly shift funds,with the sale of federal debt subject to the pressures of competition, the control of the federal money supply becomes ineffective.
The value of our money in the world is dependent upon the buying of the government debt. The salability of the debt depends upon the "spread" or profit margin made by buying less than 100% of the value in expectation of the interest payments. The smaller interest rates put pressures on these markets that force the interest rates upward to make the debt paper saleable. When there isn't enough of this debt paper purchased in the world, the price of using it in the world goes up.
Financial institutions have a whole range of paper they use to support their financial commitments and sustain the worth of their equity assets, whether they are property or securites assets. Having world-wide assets equated to denominations of financial paper involves having the resources available to meet the millions of daily financial transactions. Thus the buying and selling of national debt paper reflects the relative weight a nation has within the global supple network.
These price mechanisms are not tied to any one type of money. An example would explain the reason for the difference in prices between Honolulu, San Francisco, and Little Rock, although each urban center uses the same currency. When the exchange occurs between two different currencies (such as between the Yen and the Peso) one nation's supply network is sort of measured against another nation's supply network.
Or rather, one distribution system against another.
A liquidity crisis is disasterous because the shortage of money due to the high burdens of debt cannot maintain the low interest rates without currency deflation in the Global market. The resulting rising interest rates however further increase the costs of debt burdens.
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Gino Napoli
490 31st Avenue # 204
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California 94121
High School Math Teacher
Terra Nova High School
Pacifica, California
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