Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Liquidity Trap

What it is:

Liquidity trap describes the macroeconomic conditions under which interest rates cannot be pushed any lower, rendering monetary policy ineffective. 

How it works (Example):

Named in reference to the associated overabundance of money held in depository savings accounts, a liquidity trap occurs upon the convergence of low interest rates and a widely-held perception of an imminent economic downturn. Consumers, consequently, choose to save their money in depository bank accounts rather than purchase debt securities out of concerns that a subsequent rise in interest rates will reduce the market value of their investment. Moreover, companies do not engage in borrowing or invest in expansion; this means that banks are unable to sell loans -- even at low interest rates. 

The actual "trap" becomes manifest when the economic stagnation, which results from these dynamics, cannot be affected by monetary policy on the part of a central banking authority (e.g. the Federal Reserve). In recent times, the recession experienced by the Japanese economy since the 1990s has been characterized as a liquidity trap. 

Why it Matters:

Under normal circumstances, a central bank will enlarge the money supply in a move to fuel economic activity and encourage a rise in aggregate consumer savings through gradual interest rate increases. In the case of a liquidity trap consumers are already saving at high levels, rendering such a move ineffective and inflationary.