ECONOMICS (CBSE/UGC NET)

Detailed explanation-1: -Low interest rates alone do not define a liquidity trap.

Detailed explanation-2: -The horizontal portion of the liquidity preference curve is referred to as the liquidity trap. In this portion of the curve, the demand for money is infinitely elastic with respect to the interest rate.

Detailed explanation-3: -A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Among the characteristics of a liquidity trap are interest rates that are close to zero and changes in the money supply that fail to translate into changes in the price level.

Detailed explanation-4: -So, people believe that the interest rates will soon rise which might decrease the prices of the bonds. Therefore, the demand for money depends on the rate of interest in the economy which hence makes the demand for money perfectly interest elastic.

Detailed explanation-5: -A liquidity trap is an economic situation where people hoard financial capital instead of investing or spending it as the interest rates are low and savings rates are high which renders monetary policy ineffective.