It is an economic situation in which people prefer to hoard money instead of spending or investing it. In this situation interest rates are very low and savings rate are high. Such condition is called liquidity trap. As a result the Central Bank monetary policy become ineffective to boost the economy. The major sign of liquidity trap is low interest rate or zero interest rate. In such situation, people usually prefer to hold cash instead of bonds that may result less investment in the economy.
The Central Banks manage liquidity with monetary policy. The primary tool is to lower the interest rate to encourage borrowing from banks at low rate. This policy makes loan easy and inexpensive which encourage the families and businesses to borrow money to send and invest. The liquidity trap often occur during time of severe economic recession. In such situation, businesses and families are fearful to invest or spend, no matter how much credit is available by banks. Instead of borrowing money from bank at low interest rate to invest, they prefer to hoard cash, because they don’t have confidence to invest or spend, so they do nothing. Even with low interest rate, the central bank can’t boost the economy because there is no demand on borrowing money.
There are some means to help the economy come out of liquidity trap. They may encourage the confidence in consumer to start spending and investing in economy instead of saving money.
- A big drop in prices of goods. In this situation, people can’t stop them from sending money. A huge drop on prices of goods attracts the consumer to take advantage from savings by investing and spending on low price products.
- A rise in interest rate by the Federal Reserve may lead the families and businesses to invest more rather than saving.
- An increase in government sending on economy may implies that government is confident and committed to boost the national economy. This tactic may fuels job growth.