Liquidity trap

A liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt (financial instrument) which yields so low a rate of interest."

Negative natural interest rates and a zero lower bound are necessary conditions of a liquidity trap. Temporary economic disruption (e.g. banking crises, excessive debt accumulation) and structural factors (e.g. demographic decline, inequality) can produce negative natural interest rates. Credible monetary policy can overcome liquidity traps.

A liquidity trap is caused when people hold cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Among the characteristics of a liquidity trap are interest rates that are close to zero lower bound and changes in the money supply that fail to translate into changes in inflation.

The Great Depression, the Great Recession and Japan's Lost Decades are examples of liquidity traps.

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