A liquidity trap occurs when
A)any additions to the monetary base are held as cash by people or reserves at banks.
B)the Fed increases the money supply, causing the expected inflation rate to rise more than the real interest rate declines, so that the nominal interest rate increases.
C)there are runs on banks that are solvent but illiquid.
D)the demand for loans increases in a country on the gold standard, so that the monetary supply is not able to increase and interest rates rise dramatically.

Question

Quizplus · Accepted Answer

In a liquidity trap, even if the central bank increases the money supply, individuals and banks may choose to hold onto the additional funds as cash or excess reserves rather than using them for spending or lending. This can make it difficult to stimulate economic growth and inflation through traditional monetary policy measures such as lowering interest rates. Option A accurately describes this situation. Option B describes the opposite of a liquidity trap, where increasing the money supply causes interest rates to rise rather than fall. Option C describes a bank run, which is a separate issue from a liquidity trap. Option D describes a scenario specific to a country on the gold standard and is not applicable to all situations of a liquidity trap.

A Liquidity Trap Occurs When