In a situation known as the Liquidity Trap, the LM

Solution

A liquidity trap is an economic scenario where interest rates are very low, yet people hoard cash instead of spending or investing, rendering conventional monetary policy ineffective. In a liquidity trap, the economy faces a unique set of conditions that alter the traditional impact of economic policies: 

• Horizontal LM Curve: At very low interest rates, the demand for money becomes perfectly elastic. People are willing to hold any amount of additional money supply as idle cash balances rather than investing it in bonds, which they expect will drop in price once interest rates eventually rise.
• Ineffective Monetary Policy: Because any increase in the money supply is simply absorbed or hoarded by the public, the Central Bank cannot drive interest rates any lower to stimulate investment. Consequently, shifts in the LM curve do not change the equilibrium level of output.
• Maximum Fiscal Policy Effectiveness: Since the LM curve is horizontal, there is no crowding out effect. Usually, increased government spending (Fiscal Policy) drives up interest rates, which reduces private investment. In a liquidity trap, interest rates remain unchanged despite higher government spending, allowing the full multiplier effect to increase total output.