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What is a liquidity trap?

Under normal circumstances, when there is an increase in the money supply the interest rate should decrase because money is more abundant hence the cost of borrowing is low. In a liquidity trap the interest rate is so low that cannot decrease further, even if there is an increase in the money supply. When a nation is in a liquidity trap, hyperinflation can occur as the demand for money is perfectly elastic like it happened in Germany with the Deutschmark. Liquidity traps usually happen during adverse conditions for example crises and wars. Fiscal policies like government spending and tax cuts can increase output during a liquidity trap but without recovering from that position.

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