Stock Market Glossary
Liquidity trap
Liquidity trap explained: why very low interest rates may fail to stimulate demand and what that means for monetary policy and investors.
In brief: A liquidity trap occurs when very low interest rates barely stimulate demand or investment. Households and companies prefer to hold cash because they expect weak growth, falling prices or persistent uncertainty.
How it works
Conventional rate cuts lose effectiveness in this setting: credit may become cheaper without being demanded. Central banks can then add asset purchases, communication measures or other unconventional tools.
Practical example
A low policy rate is not an automatic buy signal for equities. Corporate earnings and risk appetite can remain under pressure in a weak economy. The key question is whether credit demand, investment and inflation actually respond.
What investors should keep in mind
Do not confuse a macroeconomic liquidity trap with the market liquidity of a security. The first concerns monetary policy effectiveness; the second concerns how easily a particular instrument can be traded.