Why is expansionary monetary policy ineffective in the liquidity trap?
What will be an ideal response?
In the liquidity trap, people are willing to hold all of the money that is available because the interest rate or opportunity cost of holding money is very low. If the Fed increases the money supply, the interest rate will not fall. Because there is no change in the interest rate, there is no change in investment and no change in aggregate spending. As a result, expansionary monetary policy does not increase the level of output. As such, at low interest rates, monetary policy cannot affect interest rates, business investment, and consumer spending through financing and therefore can't affect aggregate demand or unemployment levels. Thus monetary policy at low interest can become ineffectual.
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