What is a liquidity trap?

A liquidity trap occurs when interest rates are so low that monetary policy becomes ineffective. In this situation, even when central banks increase the money supply or lower interest rates further, consumers and businesses do not respond by spending or investing more. Instead, they hold onto cash, leading to stagnant economic activity, despite the favorable borrowing conditions.

In a liquidity trap, the traditional tools of monetary policy lose their potency because the prevailing low-interest rates fail to stimulate economic growth. This often occurs during periods of recession or economic uncertainty when confidence is low. As a result, investing or spending does not increase, leading to prolonged periods of low demand and limited economic recovery efforts.

This concept distinguishes a liquidity trap from scenarios characterized by high-interest rates or economic models focusing primarily on inflation, as none of those capture the dynamics of ineffective monetary policy caused by persistently low rates. Similarly, a liquidity trap is not simply a cash flow enhancement tool, but rather a complex economic phenomenon that deals with how fiscal and monetary policies interact under specific conditions.