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      Question

      The "liquidity trap" refers to a situation where:

      A Banks have excess reserves and are unwilling to lend. Correct Answer Incorrect Answer
      B The demand for money becomes perfectly elastic at a very low interest rate. Correct Answer Incorrect Answer
      C The velocity of money is very high. Correct Answer Incorrect Answer
      D The central bank loses control over the money supply. Correct Answer Incorrect Answer
      E None of these Correct Answer Incorrect Answer

      Solution

      In a liquidity trap, interest rates are so low that everyone expects them to rise (bond prices to fall). Thus, the speculative demand for money becomes infinite—people hold any amount of money supplied. Monetary policy (increasing money supply) becomes ineffective as it doesn't lower interest rates further.

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