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Economics help - Liquidity trap watch

    • Thread Starter

    Could someone please explain the liquidity trap graph for me? I'm having trouble understanding it. I get what a liquidity trap is completely, but I need some sort of breakdown / explanation of the graph as it is confusing me.



    If I’m not mistaken, this question had to do with IS-LM curve (equilibrium in goods and money market) in combination.

    Liquidity trap occurs when LM curve is flat/horizontal meaning money demand is perfectly elastic to changes in interest rates.

    This would mean that fiscal policy, as it affects IS curve, will have its maximal effect for the economy while monetary policy, which affects LM curve, will have no influence in changing level of output.

    For example, a fiscal expansion like a rise government spending or a fall in taxation will shift IS curve to the right and output will change in the same proportion with interest rates unchanged, while a change in monetary policy won’t have any effect on output level.

    In other words, this means that it can cause 100% change compared to normal situation which has crowding out effect (when LM curve normally slopes upward) and the change in income will be less than changes in spending as higher interest rates crowds out some proportion of investment.

    Here is the equation for LM curve in money markets

    LM curve : L = kY - hI
    L = money demand
    Y = income or output
    I = interest rates
    k = sensitivity of L to Y
    h = sensitivity of L to I

    In this case, h is infinity so LM curve will automatically be flat.
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