What a Liquidity Trap Is and Why We’re Looking at One

The Federal Reserve is doing everything it can to keep the U.S. economy from crashing during the shutdown to fight the Covid-19 pandemic. But some people fear that the Fed has fallen into a “liquidity trap.” That’s a situation in which the central bank’s efforts to stimulate spending fail because people hoard cash instead.

“Liquid” means easy to spend, like cash. Bonds aren’t as liquid, but they earn interest. So in ordinary times, people keep some money in cash for spending and some money in bonds for investing. But when the interest rate on bonds falls to zero, people might as well keep all their money in cash.