A liquidity trap occurs when interest rates are low and savings rates are high, rendering monetary policy ineffective in stimulating the economy. In this scenario, even when central banks implement measures like lowering interest rates or increasing the money supply, consumers and businesses prefer to hold onto cash rather than invest or spend. This behavior can be attributed to a lack of confidence in economic growth or expectations of deflation. As a result, aggregate demand remains stagnant, leading to prolonged periods of economic stagnation or recession.
In a liquidity trap, the standard monetary policy tools, such as adjusting the interest rate , become less effective, as individuals and businesses do not respond to lower rates by increasing spending. Instead, the economy may require fiscal policy measures, such as government spending or tax cuts, to stimulate growth and encourage investment.
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