What is liquidity trap?

Solution

Liquidity Trap. It is a situation of very low rate of interest where people expect the interest rate to rise in future and consequently bond prices to fall. So it becomes totally un-attractive to invest money in bonds causing capital loss. People withhold, as inactive balance of any amount of money they have and nothing is invested. In such a situation speculative demand for money is infinite making the demand curve a horizontal straight line curve parallel to x-axis beyond point L as shown in Fig (a). Economists call it a situation of liquidity trap because expansion in money supply gets trapped in the sphere of liquidity trap and therefore, cannot affect the rate of interest.

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Money And Banking

What is liquidity trap?

Some More Questions From Money And Banking Chapter