Answer to Question #236415 in Macroeconomics for KAT

Question

what is liquidity trap ? if the economy was in stuck in one , would you advise the use of monetary or fiscal policy ?

Answer 1

A liquidity trap refers to a situation where the monetary policy becomes less effective dye to low interest rates combined. At the same time, consumers prefer to save rather than invest in higher yielding bonds or other investments. Stable inflation expectations eliminate an important source of macroeconomic instability, namely the possibility that economic shocks affecting inflation in the short-term become amplified via a corresponding adjustment in inflation expectations. In turn, the stability of these expectations contributes to economic welfare via a reduction of inflation risk premia contained, for example in nominal bond yields. By insuring price stability, monetary policy can thus make an important contribution to macroeconomic stability.