Question

1A-) Using the appropriate diagram and explanation, discuss what is meant by the liquidity trap

2A-) What is the relationship of the liquidity trap to the degree of effectiveness of the various economic policies?

Answer 1

1A) Liquidity trap is a situation in which rate of interest falls to such a low level that any further fall in interest rate is not possible and any monetary policy in form of increased money supply increases only idle cash balance and does not transform into investment.

2A) The monetary policy is completely ineffective in the liquidity trap situation because it only increases the cash balance in the hands of people and investment is not affected. People anticipate that rate of interest will not fall further and bond price is highest. Hence any purchase will result in capital loss. Hence cash balance increases only.

Fiscal policy is completely effective because it will shift the money demand curve and rate of interest will increase, bond price will decrease and people will increase their investment in bonds.