The Yield Curve of Keynes' Liquidity Trap

The liquidity trap is usually defined as a zero lower limit of short-term interest rates.

However you can define a yield curve of the Liquidity Trap where you have a positive lower limit of long-term interest rates.

If the Market does not reward the investor for interest rate risk at a given maturity he then prefers liquid assets over long-term assets of that maturity: it is what Keynes' termed the liquidity preference.

When a yield curve is steep the Market prefers long-term assets over short-term assets, when the yield curve is inverted the Market prefers short-term assets over long-term assets.

The normal curve marks Market indifference between short-term and long-term assets.

The Yield Curve of Keynes' Liquidity Trap is simply the normal yield curve coming out of 0% for very short term-assets.

The traditional zero lower limit is simply the short part of the Keynes' Liquidity Trap Yield Curve.

My model says that, when long-term rates get to their positive lower limit, banks stop transforming short-term rates into long-term investments of that maturity.

The phenomenon soon propagates to the entire longer part of the curve.

Then central banks, in order to increase long-term investments, the conduit of money creation, is constrained to lower short-term rates to zero without being able to generate any long-term investments.

What makes Keynes' Liquidity Trap so terrible is that it stops the money creation.

Because of Greenspan Conundrum it is highly probable that long term rates will reach the longer part of the yield curve of Keynes' Liquidity Trap before short-term rates fall to zero.

My model of the yield curve never gave a signal of a systemic collapse during the recent credit crisis: it has always predicted that the Federal Reserve had sufficient room to rescue the market and the economy.