A situation in which interest rates are already very low (near zero) and monetary policy becomes powerless to stimulate the economy, because people hoard cash rather than spend or invest even when more money is supplied.
- At very low rates people expect rates can only rise (and bond prices fall), so they prefer to hold cash, and extra money pumped in just sits idle.
- In this trap, cutting interest rates further or expanding money supply fails to raise demand, lending, or investment.
- The idea was developed by John Maynard Keynes, who argued that in such conditions fiscal policy (government spending) is needed instead of monetary policy.
- It is associated with deep recessions and deflation, as seen in Japan from the 1990s and in many economies after the 2008 global crisis.
- It links to the limits of concept monetary policy and the case for concept deficit financing and fiscal stimulus in a slump.
The concept (near-zero rates making monetary policy ineffective, with people hoarding cash) and its link to Keynes and fiscal policy are testable macro facts.
A liquidity trap means monetary policy stops working at very low rates (cash is hoarded), so fiscal policy is preferred; it is not a shortage of liquidity but an unwillingness to spend it.
Near-zero rates leave monetary policy powerless as people hoard cash; Keynes argued fiscal policy is then needed.