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    • Thread Starter

    So i understand the mechanics of the Liquidity Trap.

    Interest rates fall to near zero making bonds unattractive and consumer all holding all the money they want so Md/P doesn't change.

    However, if we rewind to what caused the Liquidity trap, it seems there are two ideas which i am unsure of which is correct.

    The one my university teaches is that:

    A fall the the level of prices causes the LM curve to shift to the right until i=0 and then AD is horizontal due to Y not changing so LRAS can never be reached.

    Second from the internet:

    An increase in the money supply by the government leads to a rightwards shift in the Ms curve in a Md - Ms diagram which means consumers wish to hold more bonds as there is excess supply and so the price of bonds increases and so the interest rate falls on them.

    As the Ms curve continues to shift right there comes a point where bond are no longer attractive and Md stays fixed, which means that any increases the the money supply do not cause a change in output, with in turn means that AD will not change, trapping QE and rendering it useless.

    My intuition tell me that the second is correct, simply due to the fact that my lecturers explanation dictates that 'prices fall' and that seems to me to be an incomplete explanation as prices don't just fall by themselves.

    But if you could provide any clarification on this that would be great.

    • Thread Starter

    Is the question unclear?

    In a liquidity trap increases increases in the real money supply do not have an effect on how much money people wish to hold. This means that as you shift the LM curve outwards (due to a fall in the price level) there is no change in Y on the ISLM model.

    This means that the AD curve is vertical. This is because a fall in the price level (an increase in the real supply of money) has no effect on the amount of money people wish to hold.

    The mechanism works because if people have no incentive to change their money demand they will not buy bonds if the real money supply increases. This means that the interest rate on bonds will not fall in response to a rise in the real money supply. Therefore there will be no increased investment because the interest rate has not changed.
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