A liquidity trap occurs when interest rates are very low, yet consumers prefer to hoard cash rather than spend or invest their money in higher-yielding bonds or other investments. In such cases, the monetary tool used by the central bank becomes ineffective. During liquidity trap people neither spend nor invest. They simply hold cash for many reasons whether personal or general.

The term was first used by economist John Maynard Keynes, who defined a liquidity trap as a condition that can occur when interest rates fall so low that most people prefer to let cash sit rather than put money into bonds and other debt instruments. The effect, Keynes said, leaves monetary policymakers powerless to stimulate growth by increasing the money supply or lowering the interest rate further.

A notable problem in a liquidity trap is that banks have trouble attracting qualified borrowers for loans. And when the interest rates are already approaching zero, there is little room for additional incentives to attract well-qualified borrowers.

But why Do People Hoard Cash in a Liquidity Trap?

People do this for several reasons such as they may have no confidence that they can earn a higher rate of return by investing. Or they may believe that deflationor falling prices is about to come, so they're waiting for better prices to emerge. Or, they may fear economic troubles ahead, in their personal lives or the economy in general. Liquidity trap may also take place during economic recession or high personal savings levels or low inflation or deflation.

Deflation can start when people choose to hold onto their money rather than spend or invest it because they believe that prices will continue to fall. In extreme cases, a deflationary spiral can develop in which price levels keep declining, leading to production cuts, wage cuts, decreased demand, and continued price declines. During such a feedback loop, a liquidity trap can emerge.

How can we handle the Liquidity Trap? : There are a number of ways out of a liquidity trap such as 

1. A rate increase: The RBI can raise interest rates, which may lead people to invest more of their money, rather than hoard it.
2. A big drop in prices: When there are real bargains out there, people just can't help themselves from spending. The lure of lower prices becomes too attractive, and the savings are used to take advantage of those low prices.
3. An increase in government spending: Government projects can fuel job growth and spending when companies hold back.
4. Quantitative easing (QE): The central bank can begin injecting money into the economy to stimulate spending and artificially lower interest rates below zero by buying longer-dated government bonds as well as other securities such as mortgage bonds.
5. Negative interest rate policy (NIRP): This extraordinary monetary policy tool was used in Europe and Japan after the 2008 financial crisis. Going below zero on nominal interest rates means imposing negative interest rates. In this case, people are charged interest rate on keeping money idle in their bank accounts.