What happens in a liquidity trap?
Answer (2)
A liquidity trap happens when interest rates are already very low—close to 0%—but people still refuse to borrow or spend money. Even when banks make loans very cheap, businesses and consumers don’t feel confident enough to invest or spend, so the economy stays weak or stagnant.This often happens during periods of economic crisis or recession. For example, during the COVID-19 pandemic, central banks around the world—including the Bangko Sentral ng Pilipinas—cut interest rates to make loans cheaper. However, many businesses were still afraid to expand, and people were saving more instead of spending, because of job uncertainty and lockdowns. In that kind of situation, even at low interest, the economy doesn’t move. That’s a liquidity trap.This is a dangerous scenario because monetary policy (cutting interest rates) becomes less effective. Governments may have to rely on fiscal policy, such as cash assistance (like ayuda) or large government projects, to restart spending and create jobs.Understanding liquidity traps helps students see why sometimes, low interest rates alone aren’t enough to fix an economy—and why trust and consumer confidence matter just as much.
In a liquidity trap, interest rates are very low (close to zero), and people prefer holding càsh rather than investing or spending, so monetary policy becomes ineffective. Even if the central bank increases the money supply, it doesn’t boost demand or economic activity because people expect no better returns or worry about the future.
