The core idea is that the government prints more money but people just hold it. If nominal interest rates are low, OK, maybe no one wants to buy more bonds (however under some assumptions this will lower bond prices and raise rates again, bonus points if you can work through the whole analysis with real and nominal rates and price level paths). But they will buy more goods, thereby stimulating aggregate demand. If they won’t buy more goods, just print even more money. The spending impulse will kick in.
For another view, Paul Krugman argues people may not expect the inflation to continue for long enough, and therefore won’t spend their money but will instead expect a future deflation further down the road. I think that creating and maintaining the inflationary expectations is quite easy, especially if the inflation will boost output and employment and thereby make politicians popular with voters. If you print money, people don’t think "hmm…that is inflationary…that means someday the central bank will have to deflate, I’ll wait six years and spend this new money when prices are really low." Yes, I see the intertemporal equilibrium concept, but nope, that fails Psych 101. Krugman also borrows the idea of an ongoing negative real rate of interest, but this describes Battlestar Galactica, not the twentieth century.
Open market operations, when tried, seem to have worked in 1932. Was Japan in a liquidity trap in the 1990s? They could have printed more money and given it to me. With an interpreter at my side, I would have spent it right away. Who knows, maybe you could have helped me. Here is a good critique of Krugman on Japan.
Perhaps there is a knife edge setting where printing too little money leads to hoarding and printing too much money leads to hyperinflation. So a risk-averse central bank is stuck. I doubt this, people don’t act so closely in accord but rather they adjust their cash balances at different speeds. So again, just print some more money to get out of the liquidity trap.
What is the evidence for a liquidity trap? Low nominal rates and the absence of a recovery? That’s not much evidence. I suspect real coordination problems are at fault in most of these settings, and hoarding is at most a secondary issue. Few serious economic problems are purely monetary in nature, yet the liquidity trap encourages us to embrace that dangerous idea.
The bottom line: I once wrote a paper arguing the liquidity trap is possible. Now I think that Milton Friedman was right all along.