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Liquidity Trap

We can think of situation in which rate of interest falls to such a low level that it becomes totally unattractive to invest money in bonds. In such a situation, demand for money becomes perfectly elastic. The demand curve assumes the shape of horizontal straight line curve parallel to the X-axis, as beyond point R in. This situation can be designated as ‘liquidity trap’.


The above analysis of the demand for money can be summarized briefly in the following way:

(1)    The demand for money (MD) is composed of a demand for active transaction balaces (MDT ) and a demand for idle asset balances for speculative purposes (MDS).



(2)    The demand for transaction balances is proportional to the level of national income.

MDT = K.Y.

(3)    The demand for asset balances (speculative purposes) depends on the rate of interest (r)

MDS = f (r)
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