Liquidity trap is a situation in which prevailing interest rates are low and savings rates are high. Liquidity trap makes monetary policy ineffective.
Liquidity trap also means that bank cash-holdings are rising and banks cannot find sufficient number of qualified borrowers even at extraordinary low rates of interest.
When liquidity trap happens?
The liquidity trap usually arises in economies where people are not buying goods and services and firms are not borrowing mainly because economic prospects look dim.
Investors are not investing because expected returns from investments are low. This happens for example when a recession is expected or beginning.
When expected returns from investments in are low, investments fall, recession begins, and cash holdings on banks' balance sheets rise. People and businesses then continue to hold cash because they expect spending and investment to be low. This is a self-fulfilling trap.
Liquidity trap implications on bond prices
In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings. They do so because of the prevailing belief that interest rates will soon rise and therefore they expect bond prices to go down.
Because bonds have an inverse relationship to interest rates, many consumers in this situation do not want to hold an asset with a price that is expected to decline.Of course, the time is of essence here. If everyone expects that prices will go down, they most likely already have gone down, and it might be a good opportunity to buy cheap before a revival.
Liquidity trap implications on monetary policy
Should the regulatory organ, the central bank, try to stimulate the economy by increasing the money supply, there would be no effect on interest rates as people would not be encouraged to hold additional cash.
Liquidity trap in the ISxLM model
The liquidity trap would be shown in the IS-LM framework if the LM curve is horizontal, making any government intervention in the money market failing.