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IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy

An economy is in a Keynesian liquidity trap, with the interest rate at a very low floor. Which statement best describes the effect of a further expansion of the money supply by the central bank?

The interest rate stays unchanged. In a liquidity trap, money demand is perfectly elastic at the low rate because people expect rates to rise and bond prices to fall, so they hoard any additional money as idle balances, making monetary expansion ineffective.

  1. AInterest rates fall sharply, stimulating investment strongly
  2. BInterest rates are unchanged because the demand for money is perfectly elastic at that rate, so extra money is simply held as idle balancesCorrect
  3. CInterest rates rise because of inflation expectations by definition
  4. DThe money demand curve becomes vertical
  5. Bond prices fall sharply as investors sell bonds for money

Explanation

In a liquidity trap people expect interest rates to rise, so bond prices will fall, and they are willing to hold any amount of extra money. Money demand is therefore horizontal at the floor rate. A larger supply moves along this flat section and leaves the rate unchanged, so monetary policy is ineffective. The vertical-demand option is the opposite of the trap.

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