- A liquidity trap occurs when nominal interest rates (deposit rates) are near zero.
- Central banks cannot reduce repo rates below zero.
- Banks’ deposit and lending rates also reach near zero.
- Effect on Monetary Policy:
- Monetary policy becomes ineffective in stimulating the economy.
- People prefer to hold cash or demand deposits.
- They expect future interest rates to rise, so they postpone investment.
- This keeps demand low, and the economy remains weak.
- The central bank is “trapped” and cannot further stimulate lending/spending.