Liquidity Trap

What is the 'Liquidity Trap'

The liquidity trap is the situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings, because of the prevailing belief that interest rates will soon rise. Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline.

BREAKING DOWN 'Liquidity Trap'

Should the regulatory committee try to stimulate the economy by increasing the money supply, there would be no effect on interest rates, as people do not need to be encouraged to hold additional cash.

As part of the liquidity trap, consumers continue to hold funds in standard deposit accounts, such as savings and checking accounts, instead of in other investment options, even when the central banking system attempts to stimulate the economy through the injection of additional funds. These consumer actions, often spurred by the belief of a negative economic event on the horizon, causes monetary policy to be generally ineffective.

Signs of the Liquidity Trap

One marker of a liquidity trap is particularly low interest rates. These low interest rates can affect bondholder behavior, along with other concerns regarding the current financial state of the nation, resulting in the selling of bonds in a way that is harmful to the economy. Further, additions made to the money supply fail to result in price level changes, as consumer behavior leans toward saving funds into lower-risk and highly liquid mechanisms. Without changes to interest rates, consumers are not motivated to invest into other options.

Low interest rates alone do not define a liquidity trap. For the situation to qualify, there has to be a lack of bondholders wishing to keep their bonds, and a limited supply of investors looking to purchase them. Instead, the investors are prioritizing strict cash savings over bond purchasing. If investors are still interested in holding or purchasing bonds at times when interest rates are low, even approaching the zero limit, the situation does not qualify as a liquidity trap.

Lenders and Borrowers

A notable issue of a liquidity trap involves financial institutions having problems finding qualified borrowers at a particular level. This is compounded by the fact that, with interest rates approaching zero, there is little room for additional incentive to attract well-qualified candidates. This lack of borrowers often reflects lower buying behavior, such as that related to higher priced, and often financed, purchases such as cars and homes.

RELATED TERMS
  1. Value Trap

    A stock that appears to be cheap because the stock has been trading ...
  2. Bear Trap

    A false signal that the rising trend of a stock or index has ...
  3. Relativity Trap

    A psychological or behavioral trap that leads people to make ...
  4. Superiority Trap

    A psychological or behavioral trap that leads people to believe ...
  5. Bull Trap

    A false signal indicating that a declining trend in a stock or ...
  6. U.S. Savings Bonds

    A U.S. government savings bond that offers a fixed rate of interest ...
Related Articles
  1. Markets

    Stocks With More Upside Due to Bear Traps (TAP, SPY)

    A bear trap is a pattern that typically leads to at least a short-term rise in prices. Here are stocks exhibiting the pattern.
  2. Trading

    Avoid These Common Investing Psychology Traps

    There are a number of very common psychological traps or errors that investors typically make. You can save a lot of money and misery by avoiding them.
  3. Markets

    Implications of the Federal Reserve's Impending Rate Hike

    The Federal Reserve begins its two-day meeting on Wednesday, September 16, and everyone is watching to see if the central bank will raise the United States target interest rate for the first ...
  4. ETFs & Mutual Funds

    How Interest Rates Affect Mutual Funds

    Find out how changing interest rates impact mutual funds, including bond and money market funds, and how higher rates can discourage investors.
  5. Markets

    What is Zero Interest-Rate Policy (ZIRP)?

    In the years following the financial crisis, several central banks have turned to zero interest-rate policy to aid economic recovery.
  6. ETFs & Mutual Funds

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
  7. Managing Wealth

    Six Biggest Bond Risks

    Don't assume that you can't lose money in this market - you can. Find out how.
  8. Investing

    Avoid These 3 Value Trap Stocks

    Investors are wise to do their homework and avoid the following companies that might be value traps.
  9. Markets

    What is Liquidity Risk?

    Liquidity risk is the risk of being unable to sell an asset fast enough to avoid loss.
  10. Markets

    5 Fixed Income Plays After the Fed Rate Increase

    Learn about various ways that you can adjust a fixed income investment portfolio to mitigate the potential negative effect of rising interest rates.
RELATED FAQS
  1. Is liquidity calculated by flow?

    Read about the differences between economic liquidity, financial liquidity and asset liquidity and how each respective type ... Read Answer >>
  2. What is liquidity risk?

    Learn how to distinguish between the two broad types of financial liquidity risk: funding liquidity risk and market liquidity ... Read Answer >>
  3. What is liquidity management?

    Take a look at the different definitions of liquidity, and find out how investors and businesses attempt to reduce exposure ... Read Answer >>
  4. How much liquidity is considered too much liquidity?

    Learn about the risks of holding too much cash or investing in assets that are too liquid, and discover how liquidity is ... Read Answer >>
  5. What is the impact of inflation on liquid assets?

    Find out why inflation is particularly problematic for liquid assets, and learn what holders of liquid assets can do when ... Read Answer >>
  6. What is the difference between a bank's liquidity and its liquid assets?

    Understand the relationship between a bank's liquid assets and its liquidity and how the financial crisis demonstrated the ... Read Answer >>
Hot Definitions
  1. GBP

    The abbreviation for the British pound sterling, the official currency of the United Kingdom, the British Overseas Territories ...
  2. Diversification

    A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique ...
  3. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  4. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  5. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  6. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
Trading Center