What does the term "liquidity trap" describe?

The term "liquidity trap" refers to a situation in which monetary policy becomes ineffective because interest rates are already at, or near, zero, and cannot be lowered further to stimulate the economy. When this happens, traditional tools of monetary policy, such as lowering interest rates to encourage borrowing and investment, lose their impact.

In a liquidity trap, even if the central bank increases the money supply, it does not lead to a decrease in interest rates due to the zero lower bound, meaning that people and businesses do not respond to the increase in liquidity by borrowing more. This can often happen during periods of economic downturn when confidence is low, and individuals prefer to hold onto cash rather than invest or spend.

Additionally, when banks hold excess reserves instead of lending them out, this situation further exacerbates the liquidity trap as it limits the effectiveness of monetary policy. People may still choose to hold onto their money rather than lend or spend it, leading to stagnant economic activity.

In summary, all of these factors contribute to the phenomenon described by the term "liquidity trap," making the comprehensive answer encompass all of the situations outlined.