What is a liquidity trap?

A liquidity trap occurs when interest rates are low, and despite this, savings rates remain high. In this situation, individuals and businesses are unwilling to spend or invest their money even with lower borrowing costs. This behavior often arises during times of economic uncertainty or recession when consumers prefer to hoard cash instead of spending it, believing that future needs may require available liquidity.

The low-interest rates typically signify attempts by central banks to stimulate the economy by encouraging borrowing and spending. However, if confidence in the economy is low, the desired effect of monetary policy can be significantly diminished, leading to stagnation. It highlights a paradox where monetary policy becomes ineffective in stimulating economic growth, as people choose to save rather than invest despite favorable borrowing conditions.

In contrast, other scenarios presented, such as high-interest rates with low consumer saving or a booming economy with low unemployment, do not capture the essence of a liquidity trap, as they imply robust economic activity and engagement with monetary policy.