Question

Write short notes Liquidity trap

Answer 1

Definition of 'Liquidity Trap'

Definition: Liquidity trap is a situation when expansionary monetary policy (increase in money supply) does not increase the interest rate, income and hence does not stimulate economic growth.

Description: Liquidity trap is the extreme effect of monetary policy. It is a situation in which the general public is prepared to hold on to whatever amount of money is supplied, at a given rate of interest. They do so because of the fear of adverse events like deflation, war.

In that case, a monetary policy carried out through open market operations has no effect on either the interest rate, or the level of income. In a liquidity trap, the monetary policy is powerless to affect the interest rate.

There is a liquidity trap at short term zero percent interest rate. When interest rate is zero, public would not want to hold any bond, since money, which also pays zero percent interest, has the advantage of being usable in transactions.

Hence, if the interest is zero, an increase in quantity of money cannot not induce anyone to buy bonds and thereby reduce the interest on bonds below zero.

Answer 2

A liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers [holding] cash [rather than] holding a debt which yields so low a rate of interest.