Question

1. Graphically show how in a liquidity trap, an expansionary monetary policy doesn’t improve output.

Answer 1

In the case liquidity trap, the monetary policy is ineffective. The LM curve is horizontal. The interest rate are at the lowest level and cannot decrease further. Expansionary monetary policy will expand the money supply by reducing interest rates but in this case the interest rate cannot be reduced further because they are at the lowest level. So, LM curve cannot shift downward. Hence, expansionary monetary policy will be ineffective in raising output in the case of liquidity trap.