Economics • Economic BasicsMedium
What is the primary implication of the 'Liquidity Trap' situation identified in Keynesian economics?
A. Nominal interest rates fall to extremely low levels, rendering monetary policy ineffective as public preference for cash becomes absolute✓ Correct Answer
B. Commercial banks refuse to lend due to high systemic non-performing assets
C. Central banks lose control over foreign exchange reserves due to capital flight
D. Inflation rises rapidly despite strict fiscal austerity measures
💡 Solution & Explanation
A liquidity trap occurs when nominal interest rates approach zero and the public anticipates bond prices to fall, causing people to hoard money rather than purchase bonds or invest. Under this condition, expanding the monetary base fails to lower interest rates or stimulate aggregate demand, neutralizing traditional monetary policy instruments. Consequently, governments must rely on expansionary fiscal policies, such as direct public expenditure, to lift the economy out of recession. This theoretical concept gained renewed attention during prolonged periods of near-zero interest rates in major global economies.
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