Money Demand, Money Supply, Liquidity Trap

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Money Demand, Money Supply, Liquidity Trap MS2 r MS1 MS3 MS4 r1 A B C D r0 Md M/P As very low interest rates, investors are indifferent between bonds and money – money demand becomes perfectly elastic. Increase in the money supply is held as cash.

Derivation of the LM-Curve With Liquidity Trap MS1 πe = 0 Md (Y1) LM A r1 A r1 Md (Y2) B r2 B r2 Md (Y3) C r0 C r0 Y M/P Y3 Y2 Y1 As income falls below Y3 , no effect on the interest rate. The LM-curve is horizontal.

Monetary Policy in a Liquidity Trap IS LM0 LM1 LM2 A r B Y0 Y1 YF Y The economy is at Y0 below full employment potential. Monetary policy is ineffective in pushing the economy beyond Y1.

Fiscal Policy in a Liquidity Trap πe = 0 r IS1 IS2 LM Y0 Y1 YF Y But, fiscal policy seems to work and you get the full multiplier effect as you move from Y0 to Y1. Why do you get the full multiplier effect?

Fiscal Policy in a Liquidity Trap πe = 0 r IS3 IS1 IS2 LM Y0 Y1 YF Y

The Fed Targets the Interest Rate – Not the Money Supply LM3 IS2 LM1 IS1 IS3 LM2 B’ C B A rtarget C’ Y Case where real sector of the economy experiences shocks causing shifts in the IS-curve. If the Fed targeted the money supply, go to points B’ and C’.