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Liquidity Trap

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Definition of 'Liquidity Trap'

The liquidity trap, in Keynesian economics, is a situation where monetary policy is unable to stimulate an economy, either through lowering interest rates or increasing the money supply.

This is a situation in which interest rates are low and savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings because of the belief that interest rates will soon rise. Bonds have an inverse relationship to interest rates so investors will not want to hold an asset with a price that is expected to decline.

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