Question

What is a liquidity trap and how does it affect monetary policy for getting the economy out of a recession?  

Answer 1

The liquidity trap is a situation in which expansionary monetary policy (increase in the supply of money) does not lift interest rates , increase taxes and, thus, does not boost economic growth.

A serious consequence of monetary policy is the liquidity trap. It is a condition in which the general public is willing, at a given rate of interest, to hang on to whatever sum of money is offered. Out of the fear of adverse events like deflation and war, they do so.

In that case, there is little impact on either the interest rate or the amount of income of a monetary policy carried out by free market operations. Monetary policy is unable to control the interest rate in a liquidity trap.

At the short-term zero per cent interest rate, there is a liquidity pit. The public does not want to keep any bonds when the interest rate is zero, because capital, which often pays zero percent interest, has the benefit of being available in transactions.