What does the term "liquidity trap" refer to?

The term "liquidity trap" refers specifically to a condition where monetary policy becomes ineffective, primarily when interest rates are at or near zero and cannot be lowered further. In such a scenario, even if a central bank attempts to stimulate the economy by increasing the money supply, businesses and consumers may choose to hold onto cash rather than borrow or spend it. This situation arises because people expect that any potential economic improvement will remain sluggish, leading to a decreased demand for loans regardless of the low-interest rates.

In a liquidity trap, the expectation of future economic conditions causes individuals to be cautious, preferring liquidity (cash) over investment in higher-risk assets. Consequently, the traditional tools of monetary policy lose their potency, as simply providing more liquidity does not spur additional spending or investment. This reflects the core characteristic of a liquidity trap, emphasizing the limitations of monetary policy when interest rates are already very low and economic confidence is lacking.