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In monetary economics, a liquidity trap occurs when the nominal interest rate is close or equal to zero, and the monetary authority is unable to stimulate the economy with traditional monetary policy tools. In this kind of situation, people do not expect high returns on physical or financial investments, so they keep assets in short-term cash bank accounts or hoards rather than making long-term investments. This makes a recession even more severe, and can contribute to deflation.

In normal times, the monetary authority (usually a central bank or finance ministry) can stimulate the economy by lowering interest rate targets or increasing the monetary base. Either action should increase borrowing and lending, consumption, and fixed investment. When the relevant interest rate is already at or near zero, the monetary authority cannot lower it to stimulate the economy. The monetary authority can increase the overall quantity of money available to the economy, but traditional monetary policy tools do not inject new money directly into the economy. Rather, the new liquidity created must be injected into the real economy by way of financial intermediaries such as banks. In a liquidity trap environment, banks are unwilling to lend, so the central bank’s newly-created liquidity is trapped behind unwilling lenders.

This WOTD is apropos of news yesterday that the U.S. Federal Reserve set a target range for the Federal funds rate to between one quarter percent and zero percent. That breaks the previous low set in 1977.

If loaning money at zero percent interest doesn’t work there’s nothing else the Fed can do to stimulate the economy. The loose money policy is as loose as it can get without paying banks to borrow money. We’re now in a liquidity trap