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al interest rates do not stimulate consumers and lowering the interest rates to 0% do not translate to reduced commercial bank lending rates (Krugman 1). In this case, the demand for money remains perfectly elastic as monetary policies by the central bank fail to arrest the situation.
In this situation, reducing the inflation rate too close to 0 % leads to deflation (Krugman 1). Even if the central bank maintains the nominal interest rates are zero, the eminent deflation will raise the real interest rates to significant levels. Increasing money supply in this case derives no economic effect since interest rates cannot fall further. Indeed, in a “Money Trap” situation monetary injections into the economy by the central bank do not reduce the interest rates depicting the ineffectiveness of monetary policies. A “Money Trap” situation relates to a condition where any monetary policy to reduce the interest rates during economic recession is futile and creates a recurring crisis that involves consumers, commercial banks, and the central bank. The “Money Trap” situation manifests in Europe where efforts to rescue the euro from the economic crush led to looming deflation and reduced economic growth (Krugman 1).
Central banks regulate money supply by buying or selling government bonds. The buying of government bonds by the central bank reduces short-term interest rates and enhances money supply by enabling commercial banks to access additional capital that increases lending and liquidity. Quantitative easing refers to unconventional monetary policies initiated by the central bank to buy government bonds and other relevant securities with the intention of lowering interest rates and enhancing money supply in the economy (BBC 1). Quantitative easing does not entail printing more money and is only applicable when short-term interest rates are at or approaching 0 %. The US Federal Reserve initiated a $4.5tn bond-buying Programme in December 2008 to drive the
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“Money & Banking Assignment Example | Topics and Well Written Essays - 500 Words”, n.d. https://studentshare.org/macro-microeconomics/1666538-money-banking.
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