Liquidity Trap

A liquidity trap occurs when a period of very low interest rates and a high amount of cash balances held by households and businesses fails to stimulate aggregate demand.

Revision Video: Keynesian Economics including Liquidity Trap (from 10:25)

There are two main aspects of a liquidity trap

Risk averse commercial banks

• Required to hold more capital
• Charging a risk premium on new loans especially to business customers

Private sector businesses and consumers

• Low on confidence
• Focused on cutting debt rather than taking out new loans

Low interest elasticity of demand (e.g. for capital investment spending)

A fall in interest rates in theory makes some capital investment projects profitable “at the margin” but interest rates are not the only factor affecting the willingness and ability of businesses to go ahead with planned investment projects

Changes in business confidence (animal spirits) can have a powerful effect on planned investment – for example, a deterioration of sentiment causes an inward shift in the investment demand curve