A liquidity trap is a situation, described in Keynesian economics, in which injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Common characteristics of a liquidity trap are interest rates that are close to zero and fluctuations in the money supply that fail to translate into fluctuations in price levels.
The liquidity trap is referred to a situation in which the savings rates are high and the prevailing interest rates are typically low. The central bank tries to decrease the interest rates by injecting money into the private banking system. This makes it impossible for the monetary policy to remain effective. In a condition of liquidity trap, the consumers keep their funds in savings and avoid bonds, because of the general belief that the rates of interest will rise again soon. Since bonds and interest rates share an inverse relationship, therefore, most of the consumers do not want to hold or invest in the assets whose price they expect will decline in the near future.
Liquidity trap is one of the most extreme effects of a monetary policy. The general public, who will be under the conditions of liquidity trap, hold on to all the money that is supplied to them, at the rate of interest provided to them. This usually takes place in the cases when they fear the happening of adverse events like war or deflation.
In such cases, there is neither an effect on the level of income of people, nor on the interest rates under open market operations carried out on the monetary policy. The monetary policy, under the liquidity trap, remains powerless to make any changes in the interest rates.
The liquidity trap usually occurs when the interest rate drop to zero percent. In this case, the general public does not want to hold any bonds because money, which is also paying zero percent interest, can at least be used in transactions unlike bonds which will be of no use under such circumstances.
Therefore, if the rate of interest is zero percent, increasing the quantity of money will not play any significant role in the inducing and motivating anyone to buy bonds, thus the interest on bonds fall below the level of zero.
Financial education is so important, but barely taught at all in our schools. Having resources online is great, but not if they are inaccessible to so many. Thanks 508!