Q1. In which of the following situations is a liquidity trap said to have occurred?
- (a) Perfectly elastic demand with respect to interest rate
- (b) Perfectly inelastic demand with respect to interest rate
- (c) Increase in money supply leads to increase in interest rate
- (d) Decrease in money supply leads to decrease in interest rate
Answer & solution
Answer: (a) Perfectly elastic demand with respect to interest rate
A liquidity trap (concept by Keynes) occurs when interest rates are so low that people prefer to hold cash rather than invest in bonds or other assets, making monetary policy ineffective. In this situation, money demand becomes perfectly elastic (horizontal LM curve) with respect to the interest rate — any increase in money supply is absorbed into idle cash hoards without reducing interest rates further.
Option 2 (Perfectly inelastic): Inelastic demand means interest rate changes have no effect on money demand — this describes a classical scenario, not a liquidity trap.
Option 3 (Increase in money supply raises interest rate): Opposite of normal monetary theory; not a liquidity trap scenario.
Option 4 (Decrease in money supply lowers interest rate): Also contrary to standard monetary theory.