In which of the following situations is a liquidity trap said to have occurred?
Show answer & explanation
Correct answer: A
Explanation
Correct Answer:
Perfectly elastic demand with respect to interest rate
Explanation:
A liquidity trap is a situation in which interest rates fall to very low levels and people prefer to hold their wealth in cash rather than invest it. In such a situation, an increase in the money supply does not significantly affect interest rates or investment. Therefore, the demand for money becomes perfectly elastic with respect to the interest rate.
Key Points:
• The concept of a liquidity trap was introduced by John Maynard Keynes.
• People prefer to hold cash rather than invest during a liquidity trap.
• Interest rates remain extremely low.
• Monetary policy becomes less effective in stimulating the economy.
Additional Facts:
• Liquidity traps are often associated with periods of economic recession.
• Increasing the money supply has a limited impact in such situations.
• Fiscal policy is generally considered more effective than monetary policy during a liquidity trap.
Important Questions:
Q1: Who introduced the concept of a liquidity trap?
Ans: John Maynard Keynes.
Q2: What happens to interest rates during a liquidity trap?
Ans: Interest rates remain at very low levels.
Q3: Which policy is generally more effective during a liquidity trap?
Ans: Fiscal policy.