Is monetary policy impotent in the presence of a liquidity trap?

Rishi Sunak, the UK’s Chancellor of the Exchequer and head of Her Majesty’s Treasury, recently announced an ambitious and unprecedented coronavirus aid package. By offering to pay up to 80% of furloughed workers’ wages, the policy is projected to decrease the post-coronavirus unemployment rate from 8% to 6%. This follows a similar business rescue proposal in Scotland as well as the Bank of England’s decision to cut the base interest rate to a record low of 0.1%. While both the wage subsidy, which is considered a fiscal policy, and the interest rate cut, a monetary policy, are designed to stimulate the UK economy, the fact that the former policy was implemented at all owes much to the work of John Maynard Keynes.

Keynes, a prominent Great Depression-era economist, published ground-breaking findings in his work The General Theory of Employment, Interest and Money about how governments and central banks could tackle economic recessions. He argued that in times of crisis, such as during the Depression, monetary policy became impotent due to a phenomenon known as the liquidity trap. The existence of a liquidity trap, which is where individuals hoard - instead of spend - cash when interest rates are low, means that governments must use expansionary fiscal policy (i.e. increase their spending) during downturns, much like Sunak has done. The increased spending is said to stimulate the economy with a multiplier effect, resulting in expenditure-induced economic recovery.

Therefore, though the Bank of England’s rate cut will likely also contribute (the link is to a German study, but its findings are relatively universal) to the UK’s post COVID-19 recovery, the Chancellor’s fiscal policies will be the main driver of the UK economy’s fightback. Just as various national governments started to embrace Keynesian policies following the Great Recession of 2007-09, Sunak’s latest proposal attests to the enduring nature of Keynes’s work.

Applicants for Economics can consider why certain economic policies and tools are only effective in certain situations, such as how monetary policy is impotent in the presence of a liquidity trap.