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“And good morning subscribers well this morning. We re continuing to work through the a a to macro course. And i ve just recently covered this whole notion of the trap. So i thought what better way to remind my students and my subscribers.
But the liquidity trap plan to push a quick video out with regard to that very topic. So here. We go ladies and gentlemen here. We have the three diagrams which i hope you are now familiar with for the transmission mechanism.
Which demonstrates to us the ways in which changes in the financial markets or the money markets feed into the real economy and by that of course. We mean aggregate supply and aggregate demand. So just a very quick recap interest rates quantity of money here interest rate and investment here price level and real economy. As you would be familiar with over here.
So the interest rate is determined in the money markets. So where demand for money meets. The supply that then generates a rate of interest. Which subsequently leads to a level of investment i1 and we then say well that level of investment must be equivalent to a particular level of aggregate demand.
A d1. Where a d1 is equal to c..
Plus. I1. Plus. G.
Plus. X. Minus m. And focusing here.
Really on this level of investment in this particular example. So that s it ladies and gents a fairly standard transmission mechanism. Know what would happen and we ve again we ve looked at this before what will happen if there was an increase in the money supply. So here.
I m going to shift this quite significantly to the right money supply increases as a consequence. The interest rate falls. And again the interest rate here because of the very significant increase in the money supply. Know the industry and has fallen quite substantially interest rate are to take that right across to investment demand.
I so here you can see we ve got a very significant increase in the level of investment demand and as a consequence. We would anticipate that that would push our ad curve towards the full employment level of output and probably via the multiplier and the accelerator processes and we might end up somewhere over here ad..
Where this time. We re saying that ad has increased because primarily the level of investment has gone up from i1 to i2 and all the other factors see i sorry c g. And net exports. We re saying that they have remained the same and effect k.
Therese paribas were isolating them and making this link between the change in and the interest rates and the change in ad. We re making that primarily due to the level of investment meant okay so what s this thing called the liquidity trap ladies and gentlemen well this arises whenever the investment demand schedule is highly sensitive or rather insensitive in this instance to changes in the interest rate. Now that would mean if you have a fill think about that in your mind. You probably click that it s already that would mean that the investment demand schedule.
The investment demand curve is very inelastic like so this one on i d. Now. What does that mean in terms of our interest rates and the levels of investment well. If we take this original level r1 and just carry on that would mean that our first level of investment demand would be right there i won.
But yet in spite of this very significant increase in the money supply in spite of the very significant reduction in the best area to the interest rate. The new and subsequently higher it is higher. But only marginally the new rate of interest leads to a much smaller increase in the level of investment amount that s it there it is gentlemen and so as a consequence rather than a d1 shifting all the way around here moving very close to the real economy. Full employment level of output and eating up all that spare capacity instead of that maybe ad.
My only shift to here to ad. 2..
And so we end up going from y1 to y2 instead of maybe y1 to y2. Which is way over here. So this is what is know ladies and gentlemen as the liquidity trap. It means that particularly in this case capital.
Investments and firms who make these capital investments. They are not bothered whether the interest rate is 10 percent or zero percent. It makes hardly a jot of difference and as a consequence. The investment demand remains fairly static now think about reasons.
Why that might be the case why might firms regardless of the barriers of interest and the level of interest. Why might they be unwilling and reluctant to invest well it can be to do obviously with confidence it can be to do with uncertainty and if you think about what has happened in the uk economy since the great recession excuse me since the great recession of 2008. What was the bank of england s a medium response to bring interest rates. Very swiftly down from about five and a quarter percent down to and historic low at the time of.
05. Percent and a further reduction subsequently to where we are today 025. Percent. Have firms been purchasing capital equipment like it s going on a fashion.
No they haven t why not because they re still there s this global uncertainty surrounding it think about the amount of a money. Which has been pumped into the economy..
Not just in the uk. But globally. We have seen money supply ratcheted up like never before so we ve got four hundred and thirty five billion of qe into the uk economy an additional ten billion of corporate bonds all into the financial sector have banks being able to lend this out because firms can t get hold of it quickly enough. No they haven t the sitting on it in many instances so we ve got all this liquidity in the system.
But due to this very inelastic nature investment demand this then becomes a bit of a problem and we refer to as li. The quiddity trap and of course. It s not just our own economy. Where we ve been pumping in billions of qe america europe.
Everybody s been doing it we re all playing the same game. But yet. It s not yielding. The significant gains and ad that theory certainly would tell us might arise.
So that ladies and gentlemen is the liquidity trap. And we ll be back in the next couple of videos with crowding in and crowding out keep subscribing send me any questions questions are coming in a little bit thick and fast at the moment obviously as you finish. Mocking sounds and move into the real thing. So that s grit sea and air.
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