Liquidity Trap
A liquidity trap is a state where the policy rate is at or near the effective lower bound and extra money is hoarded rather than spent, so conventional rate cuts stop working.
Definition
When money and short bonds are near-perfect substitutes at i ≈ 0, open-market operations that swap them do not change spending. Keynes named the trap; Krugman and Eggertsson–Woodford formalized the modern ELB version. Unconventional tools (QE, forward guidance, fiscal) are the remaining levers.
Why it matters
If you are in a trap, ‘just cut 25’ is theater. The relevant objects become real rates via inflation expectations, QE, and fiscal.
Case
Japan from the late 1990s and the US/EA after 2008–09 ran years of near-zero rates with sticky slack. The recovery arguments were about QE and fiscal, not another 12.5 bp.
How to read it
Check the ELB, inflation expectations, and whether credit is quantity-rationed. A low rate with a functioning credit channel is not automatically a trap.
Key papers
Landmark references with real publisher or arXiv links — not token-overlap noise.
- It's Baaack: Japan's Slump and the Return of the Liquidity TrapKrugman · 1998 · Brookings PapersModern liquidity-trap restatement.