Liquidity Trap

Posted in Finance, Accounting and Economics Terms, Total Reads: 565
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Definition: Liquidity Trap

When the government adopts an expansionary monetary policy, money is injected into the economy to increase spending and economic growth by keeping the interests rates low thereby discouraging savings and encouraging investments into bonds.


However, at times there is an inverse effect (for example, when investments fall and a recession begins) where people choose to hold on to their savings in spite of the low interest rates avoid bonds expecting spending and investments to be low, in the hope that interest rates would rise later or there would be deflation in the market.


This situation is called a Liquidity Trap in which the effectiveness of the macroeconomic policy is nullified.

 

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