Definition
A liquidity trap is a condition in which short-term interest rates have fallen close to zero, yet the economy remains weak and additional monetary easing fails to spur more borrowing, spending, or investment.
In normal times, a central bank fights a downturn by cutting interest rates to make borrowing cheaper. In a liquidity trap, rates can fall no further in any meaningful way, so the central bank's main tool becomes ineffective — the economy is, in effect, stuck.
Why it matters
How it works
When interest rates approach zero, the opportunity cost of holding cash nearly vanishes, so people and firms are content to sit on money rather than lend or invest it. Further easing simply adds liquidity that is hoarded rather than spent, leaving demand stuck below potential. Because the central bank cannot push nominal rates much below zero, its primary lever is jammed. This is the textbook case for fiscal policy — government spending and tax cuts can raise demand directly without relying on lower rates. Central banks may also turn to unconventional measures, such as large-scale asset purchases or shaping expectations about future policy, to regain some traction.