Question

Explain the liquidity trap and its connection to the ZLB

Answer 1

The liquidity trap is a situation when the money demand in the economy is so high that any amount of liquidity released by the Central bank fail to create any demand in the economy and the people just keep the extra cash with them. It is a situation when the interest rates are close to zero or very low.

At this point, the individuals expect the interest rates to rise (because it can't go lower), any increase in the rates will decrease the price of the bonds and increase the return causing loss to the people who are already holding the bonds with them. The liquidity traps generally occur at the point where the money demand is very elastic and close to zero.