Economics • Economic BasicsMedium
What is the 'Liquidity Trap' as described in Keynesian economics?
A. A situation where interest rates are very low and people prefer holding cash rather than bonds, rendering monetary policy ineffective✓ Correct Answer
B. A situation where commercial banks refuse to lend to creditworthy borrowers due to high systemic risks
C. A phenomenon where foreign investors withdraw liquidity rapidly during a currency crisis
D. An economic condition where the central bank loses control over foreign exchange reserves
💡 Solution & Explanation
A liquidity trap occurs under Keynesian economic theory when nominal interest rates approach zero and monetary policy becomes ineffective because individuals and financial institutions prefer holding liquid cash rather than low-yielding bonds in anticipation of future interest rate hikes. During such phases, expanding money supply fails to stimulate borrowing or aggregate demand because asset prices are perceived to have peaked.
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