Liquidity Trap
AdvancedA liquidity trap is a situation in which interest rates are very low, close to zero, and further cuts or increases in the money supply fail to stimulate spending and investment, because people and businesses prefer to hold cash.
Normally, central banks boost a weak economy by cutting interest rates, making borrowing cheaper and saving less attractive. In a liquidity trap, rates are already near zero, so they cannot be cut much further. Even if the central bank adds more money, people may simply hold it rather than spend or invest, especially if they expect prices to fall or the economy to stay weak.
The idea comes from economist John Maynard Keynes in the 1930s. Japan’s experience of near-zero interest rates and weak growth from the 1990s, and conditions in many advanced economies after 2008, are often discussed as examples.
For example, if interest rates are already 0.1% and businesses are pessimistic about demand, a central bank adding more money may not lead them to invest more.
Economists argue that escaping a liquidity trap may require other tools, such as government spending and tax cuts, quantitative easing, forward guidance that promises low rates for a long time, negative interest rates or raising inflation expectations.
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