Suppose a liquidity trap situation exists.Which of the following is most likely to occur if taxes are cut?
A)no change in output and no change in the interest rate
B)an increase in output and an increase in the interest rate
C)an increase in output and little change in the interest rate
D)an increase in output and a reduction in the interest rate
E) none of the above

Question

Quizplus · Accepted Answer

In a liquidity trap, monetary policy is ineffective because interest rates are already very low and cannot stimulate investment. However, a tax cut can increase disposable income, leading to higher consumption and thus increasing output. The interest rate changes little because the liquidity trap situation implies that traditional monetary policy mechanisms, like influencing interest rates to stimulate borrowing and investment, are not effective.

Suppose a Liquidity Trap Situation Exists