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Liquidity Trap

A liquidity trap is a situation in which a central bank's efforts to stimulate the economy through monetary policy become ineffective because the short-term interest rate, also known as the policy rate, is already close to zero. When the policy rate is near zero, the central bank has little room to cut it further in order to stimulate demand. This can occur during times of economic downturn, when people and businesses are reluctant to borrow and spend even if borrowing costs are low.

In a liquidity trap, the central bank may be unable to stimulate demand through traditional monetary policy tools such as lowering the policy rate or increasing the money supply. This can lead to a persistent slowdown in economic activity, as well as deflation (falling prices) if the demand for goods and services is weak. To address a liquidity trap, central banks may need to rely on alternative measures such as unconventional monetary policy tools (such as quantitative easing) or the government may make more active use of fiscal policy (through changes in government spending or taxes and government borrowing).

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