What characterizes a liquidity trap?

A liquidity trap is characterized by low interest rates that coincide with high savings rates. In this economic scenario, even when interest rates are low, individuals and businesses prefer to hold onto their cash rather than spend or invest it. This situation typically occurs during periods of economic stagnation or uncertainty, where the confidence in the economy is low, prompting people to save more instead of taking on risk through spending or investment.

In essence, the low interest rates are not effective in stimulating economic activity because they do not incentivize borrowing and spending. Instead, the public may choose to keep their money liquid, reflecting a lack of trust in future economic conditions. Understanding this concept is crucial, as it highlights the limitations of monetary policy during such times, where traditional measures to stimulate the economy become ineffective.