The term Liquidity Trap was first used in 1936 by Keyenes in his General Theory to describe a situation where interest rates reach the zero-bound level. At this point monetary policy has no effect on economic activity.
The concept holds that near zero interest levels there is effective equivalence in the holding of cash with that of government or corporate debt. With little difference seen between bonds and cash, people will demand cash and continue to put all of their assets in cash as the future is unclear. Keyenes termed this Liquidity Preference, cash demand therefore is infinite. Consequences for the economy are that there is little or no capital investment in either machinery or labor which result in one consequence in increasing unemployment. As cash soars unemployment increases which discourages spending (Aggregate Demand) so money velocity decreases and comes to a halt. This situation only encourages more saving into cash and a closed loop effect begins (Money Hoarding) which leads to a greater downward spiral in the general economy (Deflation and Depression) once entered, the Liquidity Trap is very difficult to exit.
Suggested solutions in the economic literature suggest fiscal action such as (Q.E.), the buying of various assets by the Fed or the Government, Bonds, Long Term Corporate or Government is suggested along with Corporate Equities. Intervention in the Foreign Exchange Markets on a massive scale is also suggested along with Government spending and Tax Cuts as bromides to be considered.
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