Economics • Economic BasicsMedium
What is meant by 'Liquidity Trap' in Keynesian economics?
A. A situation where interest rates are very high and money supply is low.
B. A situation where nominal interest rates are close to zero and monetary policy becomes ineffective as individuals hoard cash.✓ Correct Answer
C. A state where commercial banks refuse to lend money to any borrower.
D. A condition where central banks trap foreign currency reserves.
💡 Solution & Explanation
A liquidity trap arises when nominal interest rates approach zero and monetary policy loses its transmission mechanism because economic agents hoard liquid cash rather than investing in bonds, anticipating future interest rate hikes. High interest rates and low money supply represent standard monetary tightening rather than a liquidity trap scenario. This condition famously neutralizes conventional central bank interventions, forcing governments to rely on fiscal stimulus instead.
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