What is liquidity trap?

A liquidity trap is an economic situation where interest rates are low and savings rates are high, rendering monetary policy ineffective in stimulating economic growth. In this scenario, despite central banks lowering interest rates, consumers and businesses hoard cash instead of spending or investing, leading to stagnant demand. This can occur during periods of economic downturn or uncertainty, where people prefer liquidity over investment. As a result, traditional tools of monetary policy, such as lowering interest rates, fail to encourage borrowing and spending.