Question

4) Some people believe that the economy following the Great Recession was in a liquidity trap. If true, explain why monetary policy was not effective at creating a stronger recovery.

Answer 1

A liquidity trap is a situation where the money demand in the economy is so high that it will absorb all the excess liquidity released by the economy. At this point the monetary policy becomes ineffective.

After the great recession, the monetary policy was ineffective because the business sentiments were down. At low business sentiments and low aggregate demand in the economy, no firm was ready to produce more or invest. This kept the employment rate low and the low-interest rates because of high liquidity was not effective to raise the demand. The subdued business sentiments were mainly responsible for this.