Question

In a short paragraph with complete sentences, identify and state the significance of a liquidity trap.

Answer 1

A liquidity trap is a situation when the interest rates are so low that people want to hold more cash than bonds. The economic growth slows down to the level that even the expansionary monetary policy becomes ineffective to induce people to buy bonds and spend their money on consumption and investment. Therefore even with the expansionary monetary policy, as the money supply increases, people want to hold more and more cash and nothing induces them to invest and buy bonds and the interest rates keep on decreasing. Thus, in this situation, even the expansionary monetary policy becomes ineffective in boosting demand and economic growth.