Liquidity Trap

www.investopedia.com/articles/economics/08/japan-1990s-credit-crunch-liquidity-trap.asp

A liquidity trap is an economic scenario in which households and investors sit on cash; either in short-term accounts or literally as cash on hand. They might do this for a few reasons: they have no confidence that they can earn a higher rate of return by investing, they believe deflation is on the horizon (cash will increase in value relative to fixed assets) or deflation already exists. All three reasons are highly correlated, and under such circumstances, household and investor beliefs become reality. In a liquidity trap, low interest rates, as a matter of monetary policy, become ineffective. People and investors simply don't spend or invest. They believe goods and services will be cheaper tomorrow, so they wait to consume, and they believe they can earn a better return by simply sitting on their money than by investing it. The Bank of Japan's discount rate was 0.5% for much of the '90s, but it failed to stimulate the Japanese economy, and deflation persisted.

Clearly, deflation causes a lot of problems. When asset prices are falling, households and investors hoard cash because cash will be worth more tomorrow than it is today. This creates a liquidity trap. When asset prices fall, the value of collateral backing loans falls, which in turn leads to bank losses. When banks suffer losses, they stop lending, creating a credit crunch.

http://www.interdependence.org/wp-content/uploads/2012/03/Paul-McCulley-Fellows-Paper.pdf

In a liquidity trap the animal spirits of the private sector cannot be revived by a reduction in short-term interest rates because there is no demand for credit. This effectively means that conventional monetary policy does not work in a liquidity trap.

The classic definition of a liquidity trap is: “a situation in which conventional monetary policy becomes impotent because the short-term, nominal interest rate reaches the zero lower bound” (see...