Liquidity Trap

Liquidity trap

The liquidity trap refers to a phenomenon when highly liquid assets (‘money’) get trapped in the financial system because lenders (banks) prefer to hold on to their cash rather than lend it out in poor performing investments.

When interest rates fall to very low levels the expectation is that the ‘next move’ in rates will be upwards. In this situation, the expectation is that the ‘next move’ in bond prices will be downwards (interest rates and bond prices are inverse), so the desire to hold bonds is very low and approaching zero, and the demand to hold money in a liquid form as an alternative approaches infinity. In this ‘liquidity trap’ monetary policy to stimulate economic activity becomes ineffective as rates are stuck at very low levels, with no room to reduce them further.