Question

Explain what will be the shape of the LM curve in a liquidity trap. How will the LM curve shift if there is in increase in the money supply? Would fiscal policy be effective in changing the equilibrium output?

Answer 1

liquidity trap is a situation in which the interest rates are so low that they cant be decreased further in order to target increased output, any increase in money supply wont affect the interest rates which are already extreme low, the LM curve is horizontol at this rate of interest, rhus any kind of help is what we can get from fiscal policies, as there is an increase in government ependings or decrease in taxes the IS curve shifts outwards increasing both the output and the interest rates and help the economy and the central bank to get out of the trap.