A liquidity trap is an economic situation where people hoard money instead of investing or spending it.
As a result, a nation’s central bank can’t use expansionary monetary policy to boost economic growth.
A liquidity trap causes a central bank’s monetary policy to become ineffective.
What happens in a liquidity trap?
Central banks are in charge of managing liquidity with monetary policy.
Their primary tool is to lower interest rates to encourage borrowing.
That makes loans inexpensive, encouraging businesses and families to borrow to invest and spend.
A liquidity trap often occurs after a severe economic recession. Families and businesses are afraid to spend no matter how much credit is available.
That’s what happens in a liquidity trap.
The central bank tries to provide credit at low-interest rates, making borrowing money affordable.
But instead of borrowing money and spending it, businesses and families hoard cash.
They don’t have the confidence to spend it, so they do nothing.
The central bank can’t boost the economy because there is no demand.