Definition of Liquidity trap:
Situation where bank cash-holdings are rising and banks cannot find sufficient number of qualified borrowers even at extraordinary low rates of interest. It usually arises where people are not buying and firms are not borrowing (for inventory or plant and equipment) because economic prospects look dim, investors are not investing because expected returns from investments are low, and/or a recession is beginning. People and businesses hold on to their cash and thus get trapped in a self-fulfilling prophecy.
In a liquidity trap, should a country's reserve bank, like the Federal Reserve in the USA, try to stimulate the economy by increasing the money supply, there would be no effect on interest rates, as people do not need to be encouraged to hold additional cash.
A liquidity trap is a contradictory economic situation in which interest rates are very low and savings rates are high, rendering monetary policy ineffective. First described by economist John Maynard Keynes, during a liquidity trap, consumers choose to avoid bonds and keep their funds in cash savings because of the prevailing belief that interest rates could soon rise (which would push bond prices down). Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline. At the same time, central bank efforts to spur economic activity are hampered as they are unable to lower interest rates further to incentivize investors and consumers.
How to use Liquidity trap in a sentence?
- If you find yourself in a liquidity trap you will need to attempt to get your money out as quick as you can.
- A liquidity trap isn't limited to bonds. It also affects other areas of the economy, as consumers are spending less on products which means businesses are less likely to hire.
- A liquidity trap is when monetary policy becomes ineffective due to very low interest rates combined with consumers who prefer to save rather than invest in higher-yielding bonds or other investments.
- The liquidity trap as experienced directly by the bank as there were no loans to be made as the market was saturated.
- At times your money may be in a liquidity trap and you must find a way to get it out as quickly as you can.
- Some ways to get out of a liquidity trap include raising interest rates, hoping the situation will regulate itself as prices fall to attractive levels, or increased government spending.
- While a liquidity trap is a function of economic conditions, it is also psychological since consumers are making a choice to hoard cash instead of choosing higher-paying investments because of a negative economic view.
Meaning of Liquidity trap & Liquidity trap Definition