Question

The liquidity trap refers to the

assumption that the money supply curve is vertical as a result of the Fed's control.

problem that occurs when interest rates reach such high levels that no individuals want to hold their wealth in the form of money.

situation that occurs when an excess supply of money results in people holding more money than they desire.

possibility that interest rates drop so low that people willingly hold all the additions to the money supply, rather than use it to buy bonds.

Answer 1

A liquidty trap is situation of very low interest rate, money demand become perfectly elastic (i.e., horizontal to x-axis) and monetary policy beocome ineffective because all the increase in money is kept as cash.

People kept money as cash because of opportunity cost of holding the money is nearly zero (i.e., interest rate).

The flat portion of money demand curve (MD) depicts the situation of liquidty trap.

In that portion of money demand real interest rate is very low, and any change in Money supply (i.e. increase in money supply from MS3 to MS4) does not make change in real interest rate. Hence, monetary policy is ineffective and people will hold all increase in money supply as a cash.

Answer: Option (D)

i.e., possibility that interest rates drop so low that people willingly hold all the additions to the money supply, rather than use it to buy bonds.