Liquidity Trap

A liquidity trap occurs when interest rates are low, and savings rates are high, making monetary policy ineffective in stimulating economic growth.In such situations, consumers and businesses hoard cash rather than spending or investing it, even when central banks lower interest rates. This lack of spending leads to stagnant economic activity and deflationary pressures. Liquidity traps are often associated with periods of economic recession or slow recovery, where traditional monetary policy tools, like reducing interest rates, fail to encourage borrowing and spending.

Example

During a recession, despite central banks lowering interest rates to near zero, individuals and businesses continue to save rather than spend, trapping the economy in a cycle of low demand and weak growth.