Answer to Question #260823 in Macroeconomics for Leah

Question

Discuss the concept of liquidity trap and outline its implications on the conduct of monetary and fiscal policies

Answer 1

Liquidity trap can be defined as a contradictory situation whereby interest rates are as low as almost 0% and people hold more money (Saving rate). People prefer holding cash rather than spending on illiquid assets. In this situation, the monetary policies are rendered ineffective. It simply implies that the economy is on recession and if not solved immediately can an adverse effect on the growth of the economy. This is for the reason that they prospect higher rewards (capital gains) during boom because prices of those securities increase during boom.

It is characterized by;

1.     Low interest rates

2.     Low inflation rate

3.     Slow economic growth

4.     More holding of cash

5.     Ineffective monetary and fiscal policies