A liquidity trap occurs when interest rates are so low that they fail to stimulate economic activity, despite the central bank's attempts to encourage borrowing and spending. In this scenario, individuals and businesses prefer to hold onto cash rather than invest or spend, as they anticipate that future returns will be minimal. This situation often arises during periods of economic stagnation or recession, where traditional monetary policy becomes ineffective. Keynesian economics suggests that during a liquidity trap, fiscal policy—such as government spending and tax cuts—becomes a crucial tool to boost demand and revive the economy. Moreover, the effectiveness of such measures is amplified when they are targeted toward sectors that can quickly utilize the funds, thus generating immediate economic activity. Ultimately, a liquidity trap illustrates the limitations of monetary policy and underscores the necessity for active government intervention in times of economic distress.
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