What characterizes a liquidity trap?

A liquidity trap is characterized by a situation where interest rates are very low, often near zero, and savings rates are high. In this environment, monetary policy becomes ineffective because conventional monetary tools, such as lowering interest rates, do not stimulate economic activity. When consumers and businesses are inclined to save rather than spend, even though borrowing is inexpensive, the economy can stagnate despite the favorable borrowing conditions.

In a liquidity trap, individuals may prefer to hold onto cash rather than invest or spend it, leading to a lack of demand in the economy. This behavior can occur during times of economic uncertainty or when people anticipate future economic downturns. Thus, the scenario of low interest rates combined with high savings rates aptly describes a liquidity trap, as it highlights the paradox of low-cost borrowing coexisting with reduced spending and economic stagnation.