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Liquidity trap - Essay Example


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Liquidity trap

This creates is insufficient stimulation within the economy, as a result of hoarding of cash by the operators in the economy, with the anticipation of future economic occurrences that are not favorable to cash transactions, such as deflation, insufficient aggregate demand, or the uncontrollable events(Svensson, 1). The concept of liquidity trap will affect the banking sector in various ways. First, the coming into play of the concept of liquidity trap means that the interest rates will have to drop nearly to zero. Since this occurrence creates a scenario where the short-term interest rates are low, while the savings are very high, the banking sector will be affected by insufficient lending, which then means that the revenue generation capability of the banking sector will be low (Svensson, 2). Considering that when the interest rates are low the prices of the bonds is expected to drop in the near future, many consumers avoid utilizing their money to purchase the bonds, with the fear that such bonds will not bring in good returns, and instead opts to keep their money in savings, with an anticipation that the interest rates is going to increase in the near future (Svensson, 13). Consequently, the liquid trap scenario creates a moment of low business for the economy as well as for the banking sector, thus limiting the returns that the banking sector reaps from the high economy functioning. Thus, the profitability of the banking sector is low, and thus its ability to perform its other functions

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is highly affected (Svensson, 9). Secondly, the occurrence of a liquidity trap scenario affects the banking sector through increasing the nominal debt value, which in turn means that households and firms that are indebted to the bank might easily become bankrupt, thus unable to meet their debt obligations with the bank (Svensson, 12). This scenario further affects the ability of the banking sector to continue fulfilling its mandate, since it loses money to the bankrupt firms and households, thus causing the banking sector to incur losses. The banking sector is affected negatively by the loss of value of property that is occasioned by the liquidity trap, which means that the value of the collateral the bank holds against the loans granted to firms and households deteriorates (Svensson, 1). The consequence is the loss in the net worth of the banking sector, due to the loss of value occasioned by the flop in the property prices. The turning bad of the loans obligation by both the firms and the households creates a scenario where the banking sector is not even able to acquire the necessary infrastructure, technology and expertise to continue running its operations, meaning that the output performance and the competitiveness of the sector is adversely affected (Svensson, 17). Further, the uncertainty created by the liquidity trap concept regarding the stability of the economy is yet another threat to the wellbeing of the banking sector (Svensson, 3). The concept of uncertainty in the economy is associated with the rise of financial instability, where the exchange rates for foreign currencies may not stabilize, thus could keep fluctuating depending on the expectations of the players in the financial markets. This way, the banking sector’
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Name: Course: Date: How the banking sector may be affected by the “liquidity trap” The banking sector is a deposit taking sector, which heavily relies on the deposits taken from the customers of such financial institutions, to be able to perform some of its other functions such as lending (Svensson, 2)…
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