Liquidity Trap
Tue, Apr 15A liquidity trap is an economic condition in which individuals choose to save money rather than invest or spend it. Consequently, a country's central bank is unable to implement expansionary monetary policy to stimulate economic growth.
This situation often arises when short-term interest rates are at zero (ZIRP) or negative (NIRP). In a liquidity trap, the effectiveness of a central bank's monetary policy is significantly diminished.
Central banks are responsible for managing liquidity through monetary policy. Their main strategy is to reduce interest rates to promote borrowing. Lower interest rates make loans more affordable, which encourages both businesses and households to borrow for investment and spending.
A liquidity trap frequently follows a severe economic recession. During such times, families and businesses may be reluctant to spend, regardless of the availability of credit. This reluctance is a defining characteristic of a liquidity trap.
Even when the central bank attempts to provide credit at low-interest rates to make borrowing more accessible, individuals and businesses often choose to hoard cash instead of taking out loans. Lacking the confidence to spend, they remain inactive.
As a result, the central bank is unable to stimulate the economy, as there is insufficient demand for goods and services.
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