Macroeconomics 5th Edition by Olivier Blanchard

Exercise 6

The liquidity trap
a. Suppose the interest rate on bonds is negative. Will people want to hold bonds or to hold money Explain.
b. Draw the demand for money as a function of the interest rate for a given level of real income. How does your answer to part (a) affect your answer (Hint: Show that the demand for money becomes very flat as the interest rate gets very close to zero.)
c. Derive the LM curve. What happens to the LM curve as the interest rate gets very dose to zero (Hint: It becomes very flat.)
d. Consider your LM curve. Suppose that the interest rate is very close to zero, and the central bank increases the supply of money. What happens to the interest rate at a given level of income
e. Can an expansionary monetary policy increase output when the interest rate is already very close to zero
The inability of the central bank to reduce the interest rate when it is already very close to zero is known as the liquidity trap and was first mentioned by Keynes in 1936 in his General Theory-which laid the foundations of the IS-LM model. As we shall see in Chapter 22, Japan is now in such a liquidity trap. This liquidity trap sharply limits the ability of monetary policy to get Japan out of its economic slump.