Quote: Originally Posted by
Toro 
Basically. The economy is about trust. When trust goes away, economic activity decreases.
When there is excess capacity, you have deflation. Cutting interest rates really cannot help the economy until the excess capacity goes away.
Indeed. Conventional monetary policy ceases to work in a liquidity trap because when interest rates are zero or near zero, cash and treasury debt are perfect substitutes for one another. Thus, liquidity injections implemented by Central Bank purchases of treasuries do not have the normal intended effect. They simply pile up as bank reserves and in vaults. This is exactly what happened to Japan in the lost decade.
Brian