Liquidity Trap

Question 1

What is a liquidity trap?

Answer 1

An economic situation where lowering interest rates by a central bank fails to stimulate borrowing, spending, and investment.
Occurs when people and businesses are extremely pessimistic about the economy.
Characterized by deflationary pressures and a preference for holding cash.

Question 2

Why is it called a “trap”?

Answer 2

Traditional monetary policy (lowering interest rates) becomes ineffective.
The economy gets ‘trapped’ in a state of stagnation, even with very low interest rates.

Question 3

Who theorized about liquidity traps?

Answer 3

John Maynard Keynes, a prominent British economist.
Observed the phenomenon during the Great Depression.

Question 4

What did Keynes propose as a solution to a liquidity trap?

Answer 4

Fiscal policy intervention.
Argued that increased government spending and tax cuts were necessary to stimulate demand when monetary policy becomes ineffective.

Question 5

Has a liquidity trap situation occurred in recent history?

Answer 5

There’s debate about whether Japan’s economic stagnation in the 1990s, with near-zero interest rates and weak growth, was a true liquidity trap.