November 26, 2025
8 mins read
A liquidity trap refers to a highly adverse economic scenario that usually occurs when interest rates are extremely low. Low interest rates can result in people neither spending nor investing the cash they have. Instead, they hoard their cash, which can significantly impact economic growth.
When people do not spend or invest, businesses struggle to sell their products or services, which can badly affect economic growth. The term “liquidity trap” was first used by renowned economist John Keynes.
In a liquidity trap, people prefer to keep their cash idle and do not invest it in bonds or other instruments. Hence, Keynes argued that a liquidity trap can leave monetary policymakers feeling powerless because they cannot boost economic growth by cutting interest rates. Having learnt the liquidity trap’s definition, let us delve deeper into this topic.
A liquidity trap usually happens when people are worried about the future, perhaps because of a war, a recession, or falling prices (deflation). Because of this fear, they save their money instead of spending it. At the same time, interest rates are already near zero.
Normally, a central bank like the RBI can boost the economy by cutting interest rates to encourage people to borrow and spend. But in a liquidity trap, this doesn't work. Even if loans are almost free, no one wants to borrow. This is why it's called a "trap"—the usual tools to fix the economy are stuck.
A liquidity trap doesn't just happen overnight. It's usually caused by a combination of a few key factors that create a perfect storm for the economy.
The main cause is when interest rates get so low that they are close to zero. At this point, the central bank can't cut them any further to encourage spending. Another big factor is when people start expecting prices to fall. If you think a TV will be cheaper next month, you'll wait to buy it. When everyone does this, demand dries up. This general feeling of pessimism is the final ingredient.
A liquidity trap can stop an economy from growing. When interest rates are close to zero, the central bank's main tool, monetary policy, doesn't work anymore. The bank can't make people spend or invest.
Businesses stop investing in new projects or hiring new people when they see that no one is buying. This causes the economy to grow slowly or even go into a recession. People are holding on to their money until they feel safe spending it, which makes things worse for everyone.
To get the graphical representation of the liquidity trap, we need to know what the "IS" and "LM" curves mean in the Keynesian macroeconomic model. The IS curve stands for the "Investment-Savings Curve". It shows how the goods market's current interest rate (i) and income (Y) are related. It is a downward-sloping curve. This is because, as the interest rate falls, the investment in an economy increases, thereby increasing the income or output. When the interest rate falls, it becomes easier for businesses to borrow and invest, which increases their output/income, and vice versa.
The LM curve stands for the "Liquidity Preference-Money Supply Curve". It demonstrates the relationship between the interest rate (i) and income (Y) in the money market. This is an upward-sloping curve. This is because, as income increases, the demand for money increases. When people have more income, they need more money for their transactions. Hence, the interest rate should increase to motivate people to hold the money they have.
Where both these curves (IS and LM) intersect shows the equilibrium in both the money market and the goods market. This point shows the equilibrium income and interest rate in an economy.
As we know, the liquidity trap occurs when the interest rate is really low. Consider the graph below and notice the flat part of the LM curve. At this point, the interest rate will not change if the money supply increases. Hence, any change in the interest rate will not impact income (Y), either.
When an economy is in the grip of a liquidity trap, its investment or consumption does not improve by changing the interest rate.
A liquidity trap can have severe effects on an economy. The economy can come to a standstill when people and businesses are afraid to spend or borrow. This means that the economy grows very slowly, and in the worst cases, it can even get smaller.
Unemployment rises as businesses stop growing. When people lose their jobs, they have less money to spend, which makes the economy even worse. It also makes the central bank feel like it has no power because its usual ways of boosting the economy, like lowering interest rates, don't work anymore.
If you start to notice a few clear warning signs in the economy, you might be in a liquidity trap. There are a lot of things going on that show that the normal rules of economics aren't working.
Here are some of the important signs to look out for:
Rates of Interest Close to Zero: When the central bank lowers interest rates to 0% or very close to it, that's an evident sign that the economy isn't getting better.
People are Saving, Not Spending: Even though saving doesn't pay off much, people are keeping their money instead of spending or investing it. The rate of savings in the country is very high.
Businesses Stop Investing: Companies are not borrowing money to expand or start new projects because they are pessimistic about the future.
Falling Prices (Deflation): Prices for goods and services are either stagnant or falling because there is not enough demand in the economy.
While it is difficult to break a liquidity trap, a number of strategies can still be used to overcome it. For example, the central bank can increase interest rates, thereby giving a reason to people to invest their savings and stop hoarding their cash.
The government can increase its spending to compensate for the private sector reducing its spending. When the government spends more on its projects, more people get employment and earn money. Hence, the overall economy may get a boost.
The central bank may resort to quantitative easing, wherein it can buy financial assets from commercial banks. Consequently, the price of those assets may increase, yields may decrease, and the overall liquidity in the economy may increase.
Japan is a well-known example of a country stuck in a liquidity trap. Since the 1990s, it has had near-zero interest rates and falling prices (deflation), but the economy has struggled to grow. The Nikkei 225, which is Japan's main stock index, reached its peak in 1989 and hasn't been able to reach it again.
After the 2008 financial crisis, the US also showed signs of being in a liquidity trap. The central bank lowered interest rates to zero, but the economy stayed weak and unemployment stayed high for years, so the government had to take unusual steps.
It is beneficial to have knowledge of major economic concepts, such as the liquidity trap, if you intend to invest in the Indian stock market. If you know what to look for in a liquidity trap, you can figure out why the market is acting strangely or why the RBI's usual actions aren't having the desired effect. When the economy is uncertain, you can use this information to change your trading strategies and make better choices. This is especially appropriate when the economy is uncertain. You might, for instance, choose to be more careful or use stop-loss orders more often.
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A liquidity trap occurs when people hoard cash for fear of an adverse event like war or deflation. In such a case, central banks fail to stimulate the economy even by lowering interest rates, which are anyway extremely low. A liquidity trap can result in a recession, low demand, unemployment, or deflation.
A liquidity trap is typically caused by a combination of factors, including a pessimistic view of businesses and consumers about an economy, extremely low interest rates, and expectations of war or deflation.
A liquidity trap makes it extremely difficult for a central bank to boost an economy by lowering interest rates. However, a central bank may increase interest rates, thereby giving an incentive to people to invest rather than hoard cash. It can also make a central bank resort to unconventional measures like quantitative easing.
Yes, the government can choose to spend more on its projects to deal with a liquidity trap. As the government spends more on projects, it can help people in finding employment. When more people have jobs, the overall demand can increase, thereby easing the pressure of a liquidity trap.
From the 1990s onwards, Japan has faced a liquidity trap. Even though interest rates declined in Japan, the economy did not revive and prices kept on falling. The US faced a liquidity trap after the subprime crisis of 2008. Even though interest rates were close to zero in the US by December 2008, its economy did not recover and inflation also remained low.
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