An economy is in a liquidity trap. The RBI now buys government bonds in the open market. What is the likely result?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → Money supply rises, but the extra money is held as money balances and the rate of interest does not fall below rmin.
The question joins two ideas: an RBI purchase of bonds raises the money supply, and in a liquidity trap extra money does not lower the rate of interest.
Option (1) Money supply rises, the demand for bonds rises and the rate of interest falls below rmin. — Incorrect. rmin is the floor of the rate of interest. In a liquidity trap the rate is already at this floor, and the extra money does not raise the demand for bonds.
Option (2) Money supply does not change, since nobody holds bonds in a liquidity trap. — Incorrect. The RBI pays for the bonds it buys, and this payment raises reserves and money supply.
Option (3) Money supply rises, but the extra money is held as money balances and the rate of interest does not fall below rmin. — Correct. Everyone expects the rate to rise and bond prices to fall. So people just keep the new money and do not buy bonds.
Option (4) Money supply falls, and the rate of interest rises above rmin. — Incorrect. A purchase of bonds by the RBI adds to reserves. Only a sale reduces the money supply.
NCERT (2026-27): “3.4 POLICY TOOLS TO CONTROL MONEY SUPPLY … When RBI buys a Government bond in the open market, it pays for it by giving a cheque. This cheque increases the total amount of reserves in the economy and thus increases the money supply.” “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. The speculative money demand function is infinitely elastic here.” |