What it is:
Liquidity trap describes the macroeconomic conditions under which interest rates cannot be pushed any lower, rendering monetary policy ineffective.
How it works (Example):
Named in reference to the associated overabundance of money held in depository savings accounts, a liquidity trap occurs upon the convergence of low interest rates and a widely-held perception of an imminent economic downturn. Consumers, consequently, choose to save their money in depository bank accounts rather than purchase debt securities out of concerns that a subsequent rise in interest rates will reduce the market value of their investment. Moreover, companies do not engage in borrowing or invest in expansion; this means that banks are unable to sell loans -- even at low interest rates.
The actual "trap" becomes manifest when the economic stagnation, which results from these dynamics, cannot be affected by monetary policy on the part of a central banking authority (e.g. the Federal Reserve). In recent times, the recession experienced by the Japanese economy since the 1990s has been characterized as a liquidity trap.
Why it Matters:
Under normal circumstances, a central bank will enlarge the money supply in a move to fuel economic activity and encourage a rise in aggregate consumer savings through gradual interest rate increases. In the case of a liquidity trap consumers are already saving at high levels, rendering such a move ineffective and inflationary.