• Leverage Ratio
  • Liquidity ratio
  • Liquidity Trap
  • Liquidity Trap

    DEFINITION OF 'Liquidity Trap'

    Situation where an increase in money supply does not cause the fall in rate of interest is called liquidity trap.

    Explanation

    During the recession, an economy is characterised  by the fall in the output and employment opportunities. Government has to deal with such crisis. Government must use different policy measures to overcome the recession. Monetary policy is one of the measures that is operated through the central bank of country. But there may be situation where the increase in money supply is not able to reduce the rate of interest in the market. This is called liquidity trap.

    Now question arises that why does it happen?

    for understanding it in indepth , lets assume that wealth of individual can be divided into two parts : Money and Bond. Bond price is inversely related to the rate of interest in the market. At the higher rate of interest, lesser demand is made for the money.

    If the rate interest is higher in the market, then people would expect that in future rate of interest is likely to fall down. Thus, they invest in bond.On other hand, when rate of interest is lower, they do not tend to invest in bond. They anticipate rise in rate of interest in future. Thus, there is lesser opportunity cost of holding the money at zero or near zero rate of interest. Thus, people will keep the infinite amount of money in inactive form. Liquidty trap makes the monetary policy ineffective. 

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