During a recession, central banks stimulate the economy by encouraging spending and lowering interest rates. However, most people become too afraid to invest or spend, so they end up saving money instead.

During 2020/21, the world's biggest central bank, the Federal Reserve, broke all monetary records. In a matter of a single year, it “printed” more money than has ever existed since the USD became a currency. Although “printing money” is a colloquialism, it is understood that a central bank increases money supply by buying government securities from financial institutions.

liquidity-trap.png To rescue the stock market amid pandemic fears, the Fed increased the money supply to historic levels. Source: Board of Governors of the Federal Reserve System (US)

As you might imagine, such drastic actions only occur during major recessions. This applies to liquidity traps as well. Despite that borrowing is cheaper than ever, the disposition of both businesses and individuals is such that they would rather consolidate — hoard money — rather than spend or invest it.

Effectively, a liquidity trap means that the trust in economic recovery is exceedingly low. In turn, by keeping the interest rates low at the same time as people hoard money, this only damages the economy further. Therefore, a liquidity trap can be recognized by five major indicators:

  • Stagnant wages because companies are hesitant to expand

  • Businesses don't spend extra profit on expansions but stock buybacks to artificially boost their stock shares.

  • Stagnant prices. Although money supply increases inflation, during a liquidity trap, people hold off from spending much because they expect that prices will be even lower. Thus, they trigger a self-fulfilling prophecy.

  • Near-zero interest rates don't increase borrowing rates because there is no confidence in economic recovery.

  • Interest rates have to be near-zero as the key prerequisite for a liquidity trap to happen.

Among developed nations, one of the most entrenched examples of a liquidity trap is the Japanese economy. Due to many factors that eliminate the free market flow, such as guaranteed employment, an aging population, and corporate monopoly, Japan has been stuck in a liquidity trap for decades.

A central bank can attempt to pull the economy out of the liquidity trap by increasing interest rates, which is called tapering. It does so by reducing its purchase rate of government securities. Moreover, the federal government could increase government spending to bring back confidence in the economy, by reducing the unemployment rate.