Consider the following statements about a liquidity trap:
(A) Everyone expects the rate of interest to rise in future.
(B) Nobody wishes to hold bonds.
(C) Additional money injected lowers the rate of interest below rmin.
(D) The speculative demand for money is infinite.
(E) Everyone expects bond prices to rise in future.
How many of the statements given above are correct?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Three
A liquidity trap comes when the rate of interest is so low that everyone expects it to rise.
(A) Everyone expects the rate of interest to rise in future. — Correct. The rate is already at its floor, so it can only go up.
(B) Nobody wishes to hold bonds. — Correct. A rise in interest means a fall in bond prices, so bonds bring a capital loss.
(C) Additional money injected lowers the rate of interest below rmin. — Incorrect. Extra money is only held as money. It does not lower the rate below rmin.
(D) The speculative demand for money is infinite. — Correct. Everyone keeps new wealth as money, so this demand is infinite.
(E) Everyone expects bond prices to rise in future. — Incorrect. People expect bond prices to fall, since interest rates are expected to rise.
So three statements, (A), (B) and (D), are correct.
NCERT (2026-27): “The Speculative Motive … However, if the market rate of interest is already low enough so that everybody expects it to rise in future, causing capital losses, nobody will wish to hold bonds. Everyone in the economy will hold their wealth in money balance and if additional money is injected within the economy it will be used up to satiate people’s craving for money balances without increasing the demand for bonds and without further lowering the rate of interest below the floor rmin. Such a situation is called a liquidity trap. … When r = rmin, the economy is in the liquidity trap. Everyone is sure of a future rise in interest rate and a fall in bond prices. Everyone puts whatever wealth they acquire in the form of money and the speculative demand for money is infinite.” |