Question

Draw a graph to show why conventional monetary policy became ineffective during the Great Recession.​

Answer 1

Traditional monetary policy thinks that decrease with each level of interest rate, will encourage the spending and demand for money will increase. It will help the economy to recover from the recession. But, the traditional approach of monetary policy does not consider the thrift behavior of individuals who tend to save more in the expectation of recession, unemployment scenarios and expectation of rising interest rate in the coming time. It creates a scenario of a liquidity trap, when falling interest rate, fails to encourage the demand of money as it can be seen from the level of demand of money at .5% interest rate in the given graph. The graph shows that initially a decrease in interest rate leas to the increase in money demand, but after a certain level, it becomes ineffective when the liquidity trap takes place.