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IAI Actuarial Core Principles · Business Economics · Main economic schools and their key features

Keynes's concept of the 'liquidity preference' theory of interest implies that, in a deep recession with very low interest rates, expansionary monetary policy may be ineffective. Which description best captures this situation?

This is the liquidity trap. At very low interest rates people expect rates to rise and bond prices to fall, so they hold extra money as cash. Additional money supply then fails to lower rates further or boost investment, making monetary policy weak.

  1. AThe liquidity trap, where people hold any extra money as cash because bond prices are high and rates are expected to riseCorrect
  2. BCrowding out, where government borrowing raises interest rates
  3. CThe paradox of thrift, where higher saving raises income
  4. DRational expectations, where policy is fully anticipated
  5. The accelerator effect, where investment responds to output growth

Explanation

In a liquidity trap, the demand for money becomes highly elastic at a low interest rate. Extra money supply is hoarded rather than spent or used to buy bonds, so rates cannot fall further and investment is not stimulated. The other options describe different concepts.

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