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what is the best policy it has to be applied when the economy falls in liquidity...

what is the best policy it has to be applied when the economy falls in liquidity trap and price level decreases? explain with figure.

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In a condition of liquidity trap, the rate of interest falls to a lowest level which is assumed to be close to zero in the short run. This is shown by an interaction of IS and LM at an interest rate of zero percent. This is the case that occurs mostly in a recession and to combat recession, a monetary expansion is required. However, it is not warranted because monetary expansion that usually results in increasing money supply and reducing the interest rate, does not reduce the interest rate now when it is already close to zero. Since the interest rate is already zero, it cannot be reduced further Hence, if the central bank allows an open market operations, there is no effect because interest rate is already zero. Price level or level of GDP also remain unchanged. In case of zero lower bound or liquidity trap, there is an incentive to hold currency because its opportunity cost (interest amount foregone) is zero. Because people expect interest rate to fall further (as they expect further monetary contraction) there is no change in consumption or investment Since a rightward shift of the LM curve cannot bring new equilibrium due to ineffective monetary policy, the possible solution requires a rightward shift in the IS curve. This can be done by expanding government spending or reducing taxes to stimulate aggregate demand. The results arefruitful if spending and tax multipliers are large and consumers are forward looking A permanent increase in money supply will change their expectations and they will now assume that there is only a one period hike in inflation and a one period reduction in real interest rate so that they expect future interest rates would be higher or at least would not fall. I this manner, if the central bank can make credible commitment towards a permanent increase in monev supply, people would increase investment and consumption believing that there will be no further reduction in interest rates. A new solution has been proposed in terms of quantitative easing. It means central bank should set a target of high rates of increase in the monetary base to generate liquidity in the economy.

Interest rate IS1 IS2 LM 0 Y1 Y2 Real GDP

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