1. 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.

2. 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.

3. Monetary Policy in a Liquidity TrapIS
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.

4. 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?

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

6. 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’.