Economics • Economic BasicsMedium
What does the concept of 'Liquidity Trap', popularized by John Maynard Keynes, describe in macroeconomic theory?
A. A situation where nominal interest rates are very low and people prefer holding cash rather than bonds, rendering monetary policy ineffective✓ Correct Answer
B. A condition where commercial banks hold excess reserves due to strict central bank capital adequacy requirements
C. An economic state where foreign exchange reserves are insufficient to cover three months of essential imports
D. A scenario where the government faces severe budgetary deficits funded entirely through external borrowings
💡 Solution & Explanation
A liquidity trap occurs when interest rates approach zero and the public anticipates bond prices to fall, causing them to hoard liquid cash and neutralizing any expansionary monetary policy efforts by the central bank. Bank reserves and import cover pertain to different regulatory and balance of payments metrics rather than this specific monetary phenomenon. Real interest rates can sometimes remain positive even during a liquidity trap if deflationary expectations persist in the broader economy.
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