Definition
Liquidity Trap
A liquidity trap is when interest rates are so low that monetary policy loses traction, as people hoard cash and extra money fails to spur borrowing or spending.
Near zero rates, cutting further does little: households and firms hold cash rather than spend or invest, so the central bank cannot stimulate demand. Japan's lost decades are the textbook liquidity trap.
In a trap, Keynesians argue fiscal policy (government spending) must do the heavy lifting since monetary policy is impotent. India has not faced a true liquidity trap given positive rates, but the concept shaped global responses to the 2008 and pandemic crises.
Related terms
- Fiscal PolicyFiscal policy is the government's use of taxation and spending decisions, set out mainly in the Union Budget, to influence the economy.
- Negative Interest Rate PolicyA negative interest rate policy charges banks for holding excess reserves at the central bank, aiming to push them to lend rather than hoard cash during weak growth or deflation.
- Keynesian EconomicsKeynesian economics argues that aggregate demand drives output and employment, and that governments should use fiscal and monetary policy to stabilise the economy in downturns.
- Quantitative Easing / TighteningQuantitative easing is a central bank buying bonds to inject money into the economy; quantitative tightening is the reverse, draining money by reducing those holdings.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.