Liquidity trap
A liquidity trap is a situation in which interest rates are so low that monetary policy loses its power to stimulate demand.
Usually a central bank can revive a weak economy by cutting rates. Sometimes it cuts them to the floor and nothing happens. That dead end is the liquidity trap.
A liquidity trap is a situation in which interest rates are so low, at or near zero, that monetary policy loses its power to stimulate the economy. Further cuts are impossible or ineffective, and people hoard cash rather than spend or invest, so the usual mechanism by which lower rates lift demand breaks down.
When rates hit the floor
Monetary policy normally works by cutting interest rates to encourage borrowing and spending. But nominal rates cannot fall much below zero, since people would rather hold cash than pay to lend. Once rates reach this floor and the economy is still depressed, the central bank's main tool is exhausted. If, on top of this, prices are falling, the real interest rate may remain too high to revive demand even though the nominal rate is at zero, deepening the trap.
Why money gets hoarded
In a liquidity trap, injecting more money into the economy does little, because people and banks simply hold it rather than lend or spend it. With no confidence and no return to be had, additional liquidity sits idle, like pushing on a string. This is the heart of the problem: the central bank can create money but cannot force it to circulate, so the link between money and demand snaps.
Escaping it
Because conventional monetary policy fails, escaping a liquidity trap calls for other tools. Fiscal policy, government spending directly, becomes more attractive, since its multiplier is large when interest rates cannot rise to crowd it out. Central banks turn to unconventional measures such as quantitative easing and to shaping expectations, trying to convince people that inflation and recovery are coming so they spend now. Japan's long stagnation and the aftermath of the 2008 crisis made the liquidity trap, once a theoretical curiosity, a live policy problem.
The liquidity trap is the point at which the ordinary machinery of monetary policy seizes up, and it reshaped thinking about how to fight deep slumps. It is the strongest argument for keeping a cushion of positive inflation and for fiscal policy's role, because it marks the boundary of what central banks alone can do.