Question

Under what condition does a liquidity trap occur?

Illustrate a liquidity trap using IS-LM.

b) What policy measure would you suggest to help get an economy out of a liquidity trap? Show

how this policy works using IS-LM.

Answer 1

a) Usually interest rate falls when money supply is increased in long run. Liquidity trap is an economic situation when interest rate do not fall in case of rise in monetary policy or expansionary monetary policy. From M0 to M1, increase in money supply cause interest rate to fall and output level to rise while from M1 to M2 to M3, there is no reduction in rate of interest but only rise in output level. In Liquidity trap, interest rate have fallen almost to zero causing people to save their money in the form of cash rather than in stocks and bonds.

b) There are many ways to raise preference of saving in banks or raise confidence in the public that interest rate would rise soon which will induce them to invest in banks. Keynesian argues that it can be settled with expansionary fiscal policy with borrowing of government. Increase in government spending will encourage private investors to start spending. Modern monetary theory suggest that expansionary fiscal policy can be increased by money supply rather than government borrowing.