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A recession during which banks are unwilling to lend and nominal interest rates are already at or near zero. Because interest rates are so low, the central bank can do nothing further to expand the money supply. At the same time investors are unwilling to invest to help the economy grow because banks are unwilling to lend because their returns are so low. This extends the recession and indeed makes it worse. Many economists believe that the best way to end a liquidity trap is a money gift, where the government directly transfers money to consumers in hopes that they will spend it to spur investment.
Farlex Financial Dictionary. © 2012 Farlex, Inc. All Rights Reserved
liquidity trapa situation where the INTEREST RATE is so low that people prefer to hold money (LIQUIDITY PREFERENCE) rather than invest it. At low rates of interest, the MONEY DEMAND SCHEDULE becomes infinitely elastic. In these circumstances, any attempt by monetary policy to lower interest rates in order to stimulate more INVESTMENT (see MONEY SUPPLY/SPENDING LINKAGES) will be futile, and will simply result in more money being held. KEYNES argued that in a depressed economy that is experiencing a liquidity trap the only way to stimulate investment is to increase GOVERNMENT EXPENDITURE or reduce TAXES in order to increase AGGREGATE DEMAND and improve business confidence about future prosperity, encouraging people to invest.
Collins Dictionary of Economics, 4th ed. © C. Pass, B. Lowes, L. Davies 2005