Answer to Question #224884 in Macroeconomics for Anum naz

Question

3. What is a liquidity trap? If the economy was stuck in one, would you advise the use of mon-
etary or fiscal policy?

Answer 1

Liquidity trap is a situation in which,interest rates decrease to a great extent and eventually become zero.At zero interest rate,investment decline to a great extent because of low returns factor.Decrease in investment causes decrease in capital formation.

The policy that would be effective in liquidity trap would be monetary policy by central bank.Central bank should increase interest rate,which would increase investment and capital formation.