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Since the end of the Great Recession, interest rates have been at historic lows—in some cases,...

Since the end of the Great Recession, interest rates have been at historic lows—in some cases, close to zero. How is expansionary monetary policy supposed to work? How do near-zero interest rates limit the ability of expansionary monetary policy to work?

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When interest is very low, touching 0, the interest rate becomes completely insensitive to money supply because what even is supplied in the economy is absorbed by the people in form of cash. Demand money becomes perfectly elastic.

The situation is described as “liquidity trap”.

Expansionary monetary policy increases the money supply but unable to affect the real output of the economy.

In the situation of a liquidity trap, the monetary policy fails completely and to take the economy out of the liquidity trap fiscal policy has to be used. Fiscal policy is completely effective in a situation of “liquidity trap”.

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