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Bloomberg Op-Ed: The Sorrow and the Pity of Another Liquidity Trap: Brad DeLong Jul 5, 2011
A financial crisis initiates a sudden flight to safety among bondholders -- widening interest-rate spreads, diminishing the private sector's desire to sell bonds to raise capital and encouraging individuals to save more and consume less as they, too, hunker down. Thus bond prices rise, and interest rates drop. As rates fall, firms see that they can get capital on attractive terms and so issue more bonds; households see the low interest rate earned on their savings and lose some of their desire to save. The market heads toward equilibrium.


In responding to a small financial disruption, the Federal Reserve can inject more money into the economy by buying bonds for cash, increasing the amount of cash so that even at the lower velocity of money we retain the same volume of spending. This eases the decline in interest rates, spending, employment and production into a decline in interest rates alone.

But when rates become so low that there's little difference between cash and short-term government bonds, open-market operations cease having an effect; they simply swap one zero- yielding government asset for another, with their hunger to hold more safe, liquid assets unsatisfied.

This is the liquidity trap.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Carrie (migeru at eurotrib dot com) on Tue Mar 20th, 2012 at 01:02:27 PM EST
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