What characterizes a liquidity trap in monetary policy?

• A. Fiscal policy becomes ineffective
• B. Monetary policy becomes ineffective as interest rates near zero
• C. Inflation accelerates
• D. Output doesn't respond to any policy

Answer: (B)

When nominal interest rates are already very low, the central bank can’t push them down much further to stimulate demand. In a liquidity trap, people prefer holding cash and delaying spending or investment because they expect weak or uncertain returns, so the usual channel by which monetary policy boosts spending fails. The economy can’t be nudged toward more output with rate cuts, making monetary policy effectively ineffective at that bound. In this situation, fiscal policy can still raise demand directly through government spending or tax changes, which is why the emphasis is on the ineffectiveness of monetary policy near zero, not on inflation speeding up or on output being unresponsive to all policy.