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(ECONOMICS) situation in which demand confidence in banks or borrowers is so low that monetary policy (i.e., lowering interest rates) has no positive impact on the economy. A characteristic of an economic depression.

When the economy contracts, or is in a recession, it is occasionally sufficient for the authorities to lower the discount rate or the federal funds rate. This lowers the cost of borrowing money, so more people do so, more stuff is bought, and the economy recovers. But in a depression, people will hoard cash (if they have any); if the interest rate is lowered, they still won't borrow, and the banks won't lend (because they want to restore their balance sheets).

When this happens, only fiscal policy has any chance of restoring economic growth.
In the fall of 2008, the failure of so many major banks caused a global liquidity trap. For two quarters, the world economy suffered a very severe contraction, and millions of people lost their jobs.
by Abu Yahya April 17, 2010
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