Monetary policy is least effective in reversing which of the following economic situations?

• A. A supply shock resulting from rising oil prices
• B. An inflationary gap caused by excessive aggregate demand
• C. A recession caused by a negative demand shock
• D. A liquidity trap, where interest rates are near zero and consumers hoard cash

Answer: (D)

Verified step by step guidance

1. Step 1: Understand the concept of monetary policy and its typical mechanisms. Monetary policy primarily works by influencing interest rates and credit availability to affect aggregate demand in the economy.
2. Step 2: Review the different economic situations listed and how monetary policy usually impacts them. For example, in an inflationary gap caused by excessive aggregate demand, monetary policy can raise interest rates to reduce spending and cool the economy.
3. Step 3: Analyze why monetary policy is less effective in certain situations. A liquidity trap occurs when interest rates are already near zero, so central banks cannot lower them further to stimulate demand, making traditional monetary policy tools ineffective.
4. Step 4: Contrast this with supply shocks, demand shocks, and inflationary gaps, where monetary policy can still influence aggregate demand by adjusting interest rates or money supply.
5. Step 5: Conclude that among the options, a liquidity trap is the economic situation where monetary policy is least effective because the usual tool of lowering interest rates to stimulate spending is constrained.