The liquidity trap and demand for monetary assets in the U.K. in a low interest rate environment

It has traditionally been assumed that the Bank of England could use monetary policy to stimulate the economy out of a recession or economic slowdown by pushing interest rates down to low or very low levels. However, recent experience has shown that the low interest rate environment has failed to achieve the desired positive outcome. Moreover, there are questions as to whether the current monetary policy decisions will actually be effective in the long run. We will construct a monetary asset data set from the Bank of England extending the approach of Barnett (1980), Barnett, Fisher and Serletis (1992), Fisher and Fleissig (1997), Fleissig and Jones (2015, 2018), Belongia and Ireland (2106, 2017) and others. This requires determining a benchmark asset, calculating user costs for monetary assets, accommodating for changes in monetary assets and new banking regulations. After constructing a monetary asset data set that is tested using a nonparametric revealed methodology for consistency with consumer optimization, we will estimate a system of monetary asset demand equations that can be used to analyse how a representative consumer’s portfolio decisions change over time especially when interests drop to very low levels. Analysing the representative consumer’s portfolio decisions becomes extremely complicated when interest rates approach and remain at low levels because this can induce large changes in portfolio’s from illiquid assets into money that traditional linear models cannot capture. The semi-nonparametric nonlinear Fourier Functional Form can estimate the demand for monetary assets and consumer goods in a low interest rate environment. Marshallian and Morishima elasticities of substitution will be estimated to examine how a representative consumer adjusts portfolio holdings over time and especially in low interest rate environments. This is particularly important when analysing the liquidity trap and the demand for liquid assets. How close to the zero lower bound does the liquidity trap occur? Both short-run and long-run elasticities of substitution will be estimated to evaluate the impact of monetary policy by the Bank of England in the short-run and long-run. Additional simulations will be performed to examine the long-term impact of current monetary policy and the effect on future economic growth.