Question

1. Using equilibrium in the "money market” graphically demonstrate the effect of increasing the money supply in a liquidity trap. (5 pts)

Answer 1

ms, msa Rate of Interest Rmin MD Lauder trap Amount of mones

Liquidity trap is called a situation where a change in monetary policy by the Fed has no effect on the interest rate. This scenario is created if the money demand becomes horizontal at some interest rate . In the above figure the money demand becomes horizontal at R minimum which is the minimum interest rate below which the interest rate cannot fall. The initial money supply is denoted by MS one and the market is characterized by the feature of liquidity trap. Now the Fed decides to increase the money supply from MS1 to MS2 however this leads to no change of interest rate as the rate is constant at R minimum due to horizontal curve of demand . This feature of the market is known as liquidity trap in the market where the increase or decrease in money supply has no effect on the interest rate due to horizontal demand in the market.