Question

what is the liquidity trap ?what does this mean for monetary policy

Answer 1

Liquidity trap

According to Keynesian Economics, liquidity trap is an economic situation under which an increase in the supply of money, does not increase the interest rate. It means that after the interest rate has fallen into a certain level, people prefer to holding their cash, instead of holding a debt, which will provide them only a low rate of interest. Hence it will not stimulate economic growth. This is a contradictory economic situation, under which interests rates are low, and savings rates are high.

Consumers all over the world do not want to hold an asset with a price that is expected to decline anytime.  

Inshort Liquidity trap is a situation, which affected the economy at the time of monetary policy becomes ineffective. Consumers also show a tendenccy to spend less on products, which affects the overall business activities.  

Increasing rate of interests, more spending from the part of the governments, etc. are the preventive measures which can help to  overcome this situation to a certain level.

Monetary Policy

Monetary policy on the other hand is the demand side of the economic policy, undertaking by the Central Bank ,  in order to achieve sustainable economic growth and thereby macro economic goals. The following are the monetary policy measures adopted by the Central Bank.

i. Open market operations

2. Direct lending to banks

3. Bank reserve reqirments

4. unconventional emergency lending programmes

5. Managing market expectations subject to the Central Banks' credibility.  

Monetary policy consists of the management of money supply and interest rates. It aimed at meeting macro economic objectives like controlling inflation, consumption, growth and liquidity.