Money Demand, Money Supply, Liquidity Trap

1. Money Demand, Money Supply, Liquidity Trap

πe = 0
r
MS1
r1
A
MS2
MS3
MS4
B
r0
C
D
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

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

3. Monetary Policy in a Liquidity Trap

πe = 0
r
IS
r
LM0 LM1
LM2
A
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
IS1
IS2
IS3
Y0
LM
Y1
YF
Y

6. The Fed Targets the Interest Rate – Not the Money Supply

πe = 0
r
LM3
IS2
IS3
LM1
IS1
LM2
B’
rtarget
C
A
B
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’.