Under what conditions does a liquidity trap arise in the demand for money?
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Answer: A. Is perfectly interest elastic
Explanation
A liquidity trap happens when money demand becomes completely elastic with respect to interest. Investors hoard cash because nominal interest rates are near zero with no room left. Monetary expansion fails to lower interest rates further or stimulate economic activity. Liquidity preference theory explains how individuals choose between holding bonds and holding cash. When interest rates hit rock bottom, bond prices are expected to fall in future. The public prefers infinite cash holding rather than purchasing low-yielding government bonds.
Central banks face severe policy paralysis during deep depressions and liquidity traps. Fiscal policy becomes the primary tool for economic recovery when monetary policy fails. Historical examples include Japan during the prolonged economic stagnation of the nineties. Perfect interest inelasticity means money demand never changes regardless of interest rates. An increase in money supply leading to falling interest rates describes normal monetary transmission. Interest rates rising from money supply increases contradicts standard liquidity preference models.
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