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CA Foundation · Business Economics · Money Market

In the liquidity trap case of the Keynesian money market, what does the money demand curve look like and what is the effect of increasing money supply?

In a liquidity trap, money demand is horizontal at a very low interest rate because people prefer to hold any additional cash rather than buy bonds. Increasing money supply therefore cannot reduce the interest rate further, making monetary policy ineffective.

  1. AIt becomes horizontal at a very low interest rate, so more money supply does not lower the interest rate furtherCorrect
  2. BIt becomes vertical at a high interest rate, so more money supply raises the interest rate
  3. CIt becomes horizontal at a very low interest rate, so more money supply sharply lowers the interest rate
  4. DIt slopes upward at a low interest rate, so more money supply has no effect on output

Explanation

At a very low interest rate, people expect rates to rise and bond prices to fall, so they hold any extra money rather than buy bonds. Money demand becomes perfectly elastic (horizontal), and additional supply is absorbed without lowering the rate. The option claiming a sharp fall ignores this absorption.

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