Liquidity Trap

A liquidity trap is an economic situation where a central bank’s traditional monetary policy tools, such as lowering interest rates to stimulate economic activity, become ineffective. In a liquidity trap, interest rates are near or at 0%, leaving the central bank with little to no room to lower interest rates further to increase demand within an economy.

In a liquidity trap people prefer to save instead of investing or spending money despite decreasing interest rates. Expectations of poor economic conditions or deflation in the future causes people to delay their spending. It is hard for economies in a liquidity trap to recover from recessions, as monetary policy loses its effectiveness to increase demand.

The Japanese economy is an example of the liquidity trap in action, the graphic above shows the long term effects of ineffective quantitative easing, and broader monetary policy in combating long-term economic stagnation. Despite employing extensive monetary policy, Japan has struggled to significantly boost economic growth or achieve its inflation targets, leading many to argue that the country is in a liquidity trap. Japan’s long term struggle against deflation and slow economic growth highlights the limitations of monetary policy and quantitative easing to rejuvenate an economy when within a liquidity trap.