Given below are two statements:
Assertion (A): In a liquidity trap, additional money injected into the economy does not lower the rate of interest any further.
Reason (R): At the maximum rate of interest (rmax), the speculative demand for money is zero.
In the light of the above statements, choose the correct answer from the options given below:
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Both (A) and (R) are true but (R) is not the correct explanation of (A).
Assertion (A): In a liquidity trap, additional money injected into the economy does not lower the rate of interest any further. — True. In a liquidity trap the rate of interest is at its floor, rmin.
Reason (R): At the maximum rate of interest (rmax), the speculative demand for money is zero. — True. At rmax everyone expects the rate to fall, so all money is put into bonds.
Why R does not explain A?
R is about rmax, but A is about rmin, the other end of the curve.
The real explanation of A: at rmin everyone expects the rate of interest to rise and bond prices to fall, so nobody wishes to hold bonds. Extra money is used up as money balances, without raising the demand for bonds, so the rate of interest does not fall below the floor rmin.
NCERT (2026-27): “The Speculative Motive … If supply of money in the economy increases and people purchase bonds with this extra money, demand for bonds will go up, bond prices will rise and rate of interest will decline. In other words, with an increased supply of money in the economy the price you have to pay for holding money balance, viz. the rate of interest, should come down. 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. … When r = rmax, speculative demand for money is zero. The rate of interest is so high that everyone expects it to fall in future and hence is sure about a future capital gain. Thus everyone has converted the speculative money balance into bonds. 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.” |