Question

When the liquidity trap occurs the demand for money ________________.

• A. becomes perfectly interest elastic
• B. becomes perfectly interest inelastic
• C. means that an increase in money supply leads fall in the interest rate
• D. means that an increase in the money supply to an increase in the interest rate

Answer 1

The correct option is A becomes perfectly interest elastic

A liquidity trap is an economic situation where people hoard financial capital instead of investing or consuming it as the interest rates are low and savings rates are high which renders the monetary policy ineffective. So, people believe that the interest rates will soon rise which might decrease the prices of the bonds. Therefore, the demand for money depends on the rate of interest in the economy which hence makes the demand for money perfectly interest elastic.