The concept of a liquidity trap has resurfaced in India’s economic discourse in 2025. Despite the Reserve Bank of India (RBI) lowering interest rates , credit demand remains subdued. This situation mirrors the global economic challenges observed during the Covid-19 pandemic and earlier crises. The government and RBI are now working together to stimulate growth through fiscal and monetary measures.
What Is a Liquidity Trap?
A liquidity trap occurs when interest rates are very low but borrowing demand does not increase. People prefer holding cash over investing or spending. This limits the effectiveness of central banks’ efforts to boost the economy by cutting rates. The idea was first introduced by economist John Maynard Keynes during the 1930s Great Depression.
Current Scenario in India
Since February 2025, RBI has cut rates by 100 basis points. While deposit rates have fully adjusted, lending rates have only partially done so. Credit growth is steady but modest at around 10% for the first five months. Lower rates have not triggered a surge in borrowing because businesses face surplus capacity and weak demand. Investment remains cautious and concentrated mainly in infrastructure.
Why Lower Rates Are Not Enough
Lower interest rates reduce borrowing costs but do not guarantee increased investment. Firms borrow mainly for working capital, not new projects, when demand is low. Surplus capacity discourages fresh investment despite cheaper credit. Globally, low commodity prices and rate cuts have not led to broad economic growth, indicating limits to monetary policy alone.
Government’s Fiscal Push
To complement monetary policy, the government has increased capital expenditure (capex) to ₹11 lakh crore in FY26. This spending aims to stimulate investment and economic activity. Private investment is expected to rise modestly, mainly in sectors linked to government infrastructure projects. Consumer goods industries face challenges like surplus capacity and new Goods and Services Tax (GST) rules affecting inventory management.
Tax Concessions and Demand Stimulation
The government has also introduced ₹1 lakh crore in income tax concessions to boost consumer spending. GST reforms have lowered rates on many goods, potentially saving ₹48,000 crore for households. However, higher-income groups may save rather than spend this extra income, limiting the stimulus effect. Some of the additional funds may flow into savings or stock market investments instead.
Monetary and Fiscal Policy Coordination
In a liquidity trap, monetary policy alone cannot revive growth. Excessive rate cuts risk mispricing capital and future inflation without increasing demand. Hence, fiscal measures such as capex, direct income support schemes like PM Kisan and MGNREGS are crucial. The current coordination between RBI and the government reflects Keynesian economic principles, balancing monetary easing with fiscal stimulus.
Outlook and Policy Implications
Given the liquidity trap conditions, RBI’s decision to maintain status quo on rates in October 2025 is prudent. The combined fiscal and monetary approach aims to steady the economy while avoiding risks of excess borrowing or inflation. The recovery depends on broad-based demand revival and private sector investment picking up alongside government spending.
Questions for UPSC:
- Critically discuss the concept of liquidity trap and its relevance in contemporary monetary policy frameworks.
- Examine the role of fiscal policy in complementing monetary policy during periods of economic slowdown and low interest rates.
- Analyse the impact of Goods and Services Tax reforms on business investment decisions and inventory management in India.
- Estimate the effectiveness of government capital expenditure in stimulating private investment and economic growth in the Indian context.
