Liquidity Trap in India Problems and Policy Reactions

Liquidity Trap in India.

The economy of India is also experiencing leadership of a liquidity trap where the economy is experiencing cheaper credit but there is low demand to borrow. The Reserve Bank of India (RBI) has already reduced policy rates by 100 basis points by February 2025. But the growth of credit is low, and business feeling depressed. This is based on the theory of economist John Maynard Keynes during the Great Depression period where low rates do not stimulate investment or consumption.

The reason why cheaper credit is not increasing demand.

A liquidity trap is the situation in which individuals would rather hold cash or minimise debt instead of investing despite low-interest rates. The 10% credit growth of India in early 2025 is stable rather than growth. Reduction in the rates has reduced the deposit rates, yet the lending rates are sticky. Most businesses take loans to keep their businesses running rather than investing in new ventures because there are too many unused capacities and poor consumer demands to utilize.

Capex by the Government as a Growth Engine.

The government is taking note of the second hand action of the private sector and pouring in record capital expenditure ([?]11 lakh crore FY26). Over time, infrastructure projects will provide employment and crowd in investment privately. Nevertheless there is limited investment in other sectors that are not government-based. The consumer goods industries are still struggling with inventory corrections and low demand, which slugs the recovery.

Push of Tax Reliefs and Consumption.

The government has proposed Rs1 lakh crore worth of tax concession and reduction of GST on consumer goods to create demand. The actions are taken to increase disposable income and expenditure. Nevertheless, a good portion of the relief is benefiting the higher-income populations, which have less propensity to consume. Some of the money can be invested in financial markets and not direct spending to households.

Co-Ordinated Policy Approach.

This is a time when monetary-fiscal coordination is very much needed. Accommodative policies by the RBI, programmes such as PM-Kisan, MGNREGS and infrastructure expenditure give a Keynesian stimulus to demand. But the excess rate cuts may corrupt the capital pricing and lead to inflation. Therefore, the RBI will be cautious in the light of the ongoing specific spending by the government.

The Way Forward

The problem of India is how to stimulate demand without causing imbalances. The country can get out of the liquidity trap and maintain long-term growth through balanced policies which involve credit support, fiscal spending and targeted welfare.