What is ‘liquidity trap’?
Liquidity trap is a situation in which speculative demand function is infinitely elastic. It is a situation of very low rate of interest where people expect the interest rate to rise in future and the bond prices to fall. The price of a bond has inverse relationship with market interest rate.
•If the interest rate is very high people expect that it will fall in future and the bond prices will rise, so they purchase more bonds to earn capital gains in future and the speculative demand for money becomes low.
•On the contrary, if the interest rate is low people expect to rise in future and the bond prices to fall, so people sell their bonds to avoid capital loss. In this way the bonds are converted into idle cash balances. This is the extreme case of liquidity trap.
•When interest rates are very low everyone expect it to go up in future and in order to maintain cash balance and to avoid capital loss they sell the bonds. Consequently the speculative demand for money is infinitely elastic. This situation is called liquidity trap because expansion in money supply gets trapped in the sphere of liquidity trap and therefore cannot affect the rate of interest.