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

In a liquidity trap, which statement is correct?

In a liquidity trap, rates are so low that money demand is almost perfectly elastic. Extra money is held as idle balances because investors expect bond prices to fall, so expanding the money supply cannot push rates lower or stimulate spending.

  1. AInterest rates are so low that money demand is highly elastic, so extra money supply is absorbed as idle balances and fails to lower rates furtherCorrect
  2. BInterest rates are so high that firms cannot borrow, so money demand is zero
  3. CMoney demand is perfectly inelastic, so rate cuts have a strong effect on investment
  4. DIncreasing the money supply sharply raises interest rates through crowding out
  5. Bond prices are expected to rise, so everyone buys bonds with any extra money

Explanation

At very low rates, bond prices are high and investors expect them to fall, so they prefer holding cash. The money demand curve becomes flat, so extra money is hoarded and the rate cannot fall further. Monetary policy then loses effectiveness, which is why distractors suggesting strong effects or rising rates are wrong.

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