Keynesians argue monetary policy is not effective when which condition holds?

• A. The economy is in a liquidity trap
• B. No one buys bonds when the Fed conducts open-market operations
• C. The Fed is independent of political pressures
• D. Other countries do not pursue a monetary policy similar to that of the United States

Answer: (A)

Monetary policy loses its bite when the economy is in a liquidity trap. In this situation, interest rates are already very low and people prefer holding cash rather than investing in bonds or other assets. Because of that, expanding the money supply or cutting policy rates further doesn’t push down long-term rates or stimulate spending and investment—the transmission mechanism from monetary policy to higher aggregate demand basically stalls. The result is that expansionary monetary policy becomes ineffective at boosting output and employment, and fiscal measures become relatively more powerful for raising demand.

The other scenarios don’t capture this specific problem. If bond buyers were simply absent during open-market operations, that would reflect an unusual market condition rather than the typical liquidity trap story, and it doesn’t explain why monetary policy is ineffective in normal circumstances. Federal reserve independence affects credibility and political constraints, not the fundamental mechanism by which near-zero rates can mute policy effects. Lastly, if other countries pursue different policies, that affects exchange rates and trade but doesn’t by itself render domestic monetary policy ineffective in the same way a liquidity trap does.