The Theory of Liquidity leaps It is useful, in considering Japan's liquidity trap, to begin at a high level of generality, to adopt what one might almost call a philosophical stance. Within each period, consumers must pay in cash before they receive income from selling their own endowments. This is where financial intermediaries come in. Assume that there exist banks which accept deposits during the initial capital market, then allow customers to withdraw their deposits if they turn out to have H equal to 1. Deposits earn competitive interest if not withdrawn.
Consumers learn their type.
They withdraw their funds if necessary. Consumers receive income from sale of their endowment, receive bonds and deposits, and pay or receive whatever tax or transfer is needed. Consumers purchase second period consumption. They receive income from sales of endowment, and repay their money to the government. In this setting, the real interest rate is determined independent of the money supply.