SSC Selection Post 2025 PYQ — Question 5

Correct Answer

Interest rates are near zero, but people prefer holding cash instead of investing.

Explanation

A liquidity trap is an economic situation where a country's nominal interest rates are near zero, yet the central bank's monetary policy fails to stimulate economic growth or investment. In this scenario, because interest rates are extremely low, consumers and investors believe that bond yields are negligible and that interest rates can only rise in the future (which would cause bond prices to fall). As a result, instead of investing in bonds or spending, people choose to hoard cash, making expansionary monetary policy completely ineffective.

The other options represent different economic or fiscal measures rather than a liquidity trap. A central bank raising interest rates is standard contractionary monetary policy used to curb high inflation. Commercial banks stopping lending due to high default risks describes a credit crunch or banking crisis, not a liquidity trap. Government tax increases to reduce the fiscal deficit constitute contractionary fiscal policy aimed at balancing the budget.

Key Points

The concept of a liquidity trap was originally conceptualized by the famous British economist John Maynard Keynes. In this state, the public's demand for holding cash becomes perfectly elastic, meaning they will absorb any amount of money injected into the economy without investing it. Traditional monetary policy tools, such as lowering the reserve ratio or buying government securities, become powerless, requiring direct government fiscal intervention to revive demand.

Additional Facts

When an economy falls into a liquidity trap, the central bank often has to resort to non-traditional or unconventional monetary policies to stimulate the economy. One primary tool is Quantitative Easing (QE), where the central bank purchases long-term assets directly from the market to inject liquidity. Another historical response, seen in economies like Japan and parts of Europe, is the implementation of a Negative Interest Rate Policy (NIRP) to penalize commercial banks for holding excess reserves and force them to lend.

Important Questions and Answers

Question: Which policy is considered the most effective way to stimulate an economy out of a liquidity trap when monetary policy fails?

Answer: Expansionary fiscal policy, which includes direct government spending on public infrastructure, tax cuts, and direct stimulus transfers, is considered the most effective way to directly boost aggregate demand during a liquidity trap.

Question: What is the relationship between bond prices and interest rates that scares investors during a liquidity trap?

Answer: Bond prices and interest rates have an inverse relationship. During a liquidity trap, interest rates are at rock-bottom, so investors anticipate that rates will inevitably rise in the future, which would automatically decrease the value of any bonds bought at the low-interest phase.