CA Foundation · Business Economics · Money Market
The liquidity trap in Keynesian theory refers to a situation in which:
A liquidity trap occurs when the interest rate is so low that people are willing to hold any extra money as idle cash, so the money demand curve becomes horizontal. Increases in money supply then cannot reduce the interest rate further.
- AThe interest rate is so low that people hold any additional money as idle cash, making money demand perfectly elasticCorrect
- BThe interest rate is so high that nobody holds cash
- CMoney demand is completely unaffected by the interest rate
- DThe central bank cannot print more currency
Explanation
At a very low interest rate, bond prices are expected to fall, so people prefer holding cash to bonds. The liquidity preference curve becomes horizontal, meaning demand for money is perfectly elastic. Additional money supply then fails to lower interest rates further.
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