Liquidity Trap
A situation where interest rates are at or near zero and monetary policy loses its effectiveness.
What is Liquidity Trap?
A liquidity trap occurs when interest rates are so low (near zero) that monetary policy — cutting rates further or expanding the money supply — fails to stimulate economic activity. In this situation, people and businesses prefer to hold cash rather than invest or spend, even with cheap credit available. Conventional monetary policy (cutting short-term rates) cannot push rates below zero in most frameworks, so the central bank is 'pushing on a string.' Liquidity traps are associated with Japan's 'Lost Decade' (1990s–2000s) and with post-2008 advanced economies. Possible responses include fiscal stimulus, forward guidance, negative interest rates, and quantitative easing targeting long-term yields.
Example
Japan's central bank cut interest rates to near zero in 1999 and kept them there for over two decades, yet the economy stagnated with persistent deflation and low growth. Despite aggressive monetary expansion, banks held excess reserves and businesses refused to borrow — a defining example of a liquidity trap that inspired Western central banks' unconventional policies after 2008.