Liquidity Trap: Meaning and Explanation

A liquidity trap is a situation in macroeconomics where interest rates are very low (close to zero), yet people and businesses prefer to hold cash rather than invest in bonds or spend, even when central banks inject more money into the economy. This happens because people expect adverse events like deflation or economic downturns, leading them to hoard cash instead of spending or investing1 25. As a result, traditional monetary policy tools, such as lowering interest rates, fail to stimulate economic activity.

"Liquidity trap is a situation when expansionary monetary policy does not increase the interest rate, income and hence does not stimulate economic growth."3

Why Monetary Policy Is Ineffective in a Liquidity Trap

When interest rates are already near zero, central banks cannot reduce them further to encourage borrowing and investment.

People and businesses, lacking confidence in the economy, prefer to hold onto cash rather than invest or spend, regardless of how much the money supply increases1 28.

As a result, increases in the money supply do not lead to higher spending or investment, and aggregate demand remains weak.

This is known as the "zero lower bound" problem, where monetary policy becomes like "pushing on a string"-additional money does not translate into economic growth8.

Summary Table

Feature	Normal Times	Liquidity Trap
Interest Rates	Can be lowered	Already near zero
Public Behavior	Spend/invest when rates fall	Hoard cash, avoid spending
Monetary Policy Impact	Stimulates economy	Becomes ineffective

In conclusion, in a liquidity trap, monetary policy loses its effectiveness because lowering interest rates or increasing the money supply fails to boost spending or investment, leaving the economy stagnant1 2 38.

Liquidity Trap: Meaning and Explanation | Macroeconomics notes