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CA Foundation · Business Economics · Money Market

In the liquidity trap case of the money market, which statement is correct?

In a liquidity trap the money demand curve is perfectly elastic at a very low interest rate. People prefer to hold any extra money rather than buy bonds, so further increases in money supply fail to push the interest rate lower.

  1. AThe money demand curve is vertical, so changes in money supply change the interest rate sharply
  2. BThe money demand curve becomes perfectly elastic at a very low interest rate, so increasing money supply does not lower the rate furtherCorrect
  3. CThe money supply curve becomes horizontal, so the central bank cannot control money supply
  4. DInterest rates rise without limit when money supply is increased

Explanation

At a very low interest rate people expect rates to rise and bond prices to fall, so they hold any additional money rather than buy bonds. Money demand becomes perfectly elastic (horizontal), so an increase in supply does not reduce the rate further. A vertical demand curve describes the opposite extreme, not a liquidity trap.

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