In a liquidity trap:
A) fiscal policy becomes ineffective because of the high budget deficit.
B) monetary policy becomes ineffective because the nominal interest rate is close to the zero bound.
C) the aggregate price level becomes downwardly sticky.
D) any increase in government spending drives out planned investment spending.

Question

Quizplus · Accepted Answer

In a liquidity trap, the nominal interest rate is close to zero, leaving central banks with little room to stimulate the economy through decreasing interest rates further. As a result, traditional monetary policy becomes ineffective, and alternative measures such as quantitative easing may need to be employed. Fiscal policy may still be effective, but it is not hindered by a high budget deficit as stated in choice A. The downward stickiness of the aggregate price level is a separate phenomenon from a liquidity trap. And choice D is incorrect as an increase in government spending can potentially stimulate investment spending in a liquidity trap.

In a Liquidity Trap