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I've read that liquidity trap means interest rate is at its minimum and increase in real money stock will not lead to fall in interest rate because people will be demanding whatever the amount is being supplied at that minimum interest rate. Now in books they say that in this situation when government expenditure rises leading to a rise in income and hence a rise in money demand would not lead to a change in interest rate.

But according to me when the demand for money goes up it shifts the money demand curve to the right and above. Given the money supply and fixed price, this should lead to a rise in interest rate. Same confusion arises when we reduce the real money supply under the liquidity trap situation. Book says that interest rate will not go down when money supply goes up but it says nothing about money supply going down.

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  • $\begingroup$ Please can you quote and cite the actual passage from the book? You can edit it into your question. If we can see the actual quote, with sufficient context quoted with it, we can provide you a better answer. $\endgroup$
    – 410 gone
    Commented May 2, 2018 at 9:36

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I will try to explain this through ISLM model.

Consider you are an employee working for the government and earn \$1000 per month. Government follows expansionary fiscal policy and increases your pay to \$1500. Your purchasing power increases by \$ 500 when prices are held constant. This increase in your income will translate into money demand because obviously you will demand money to purchase goods and services with your extra income. This is known as transmission mechanism where increase in demand in real market transmits to money market.

In ISLM framework this could be shown as follows:

If you look carefully one interesting thing is happening here. IS curve shifts rightward due to multiplier effect because your expenditure will be somebody else's income and so on. But due to increase in the demand of money the price of money or the rate of interest also increases. This increase in rate of interest incentivizes you to reduce your demand and save more de-incentivizes the borrowers. Thus, this has an offsetting effect on the level of income. This phenomenon is known as crowding out of private investment.

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Now let us see what happens in a liquidity trap situation. Consider the same scenario where your income increases by \$500 and your money demand also increases. But rate of interest is trapped (that is why it is known as trap) here and they will not increase. This will result in no offsetting effect or no crowding out or full multiplier effect.

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If an economy is below full employment level, a corresponding increase in money supply will produce an offsetting effect on increase in money demand thereby keeping the rate of interest at their original level.

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If I've understood correctly (it's not entirely clear from the question), you're asking about a policy of fiscal expansion in a depressionary environment, accompanied by a monetary expansion.

It is conceivable that an increase in money supply, coupled with an increase in money demand, would lead to unchanged interest rates, if those two opposing forces balanced out.

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