The term 'liquidity trap' describes a macroeconomic scenario in which:

• A. monetary policy becomes ineffective because interest rates are close to zero and people prefer holding cash rather than investing
• B. the central bank raises interest rates to combat inflation, leading to decreased investment
• C. government spending increases, causing a rise in aggregate demand and inflation
• D. banks have excess reserves and lend freely, resulting in rapid economic growth

Answer: (A)

Verified step by step guidance

1. Step 1: Understand the concept of a liquidity trap in macroeconomics. It occurs when nominal interest rates are very low, close to zero, limiting the central bank's ability to stimulate the economy through traditional monetary policy.
2. Step 2: Recognize that in a liquidity trap, people prefer holding onto cash rather than investing or spending, because the opportunity cost of holding cash is very low when interest rates are near zero.
3. Step 3: Analyze why monetary policy becomes ineffective in this scenario. Since interest rates cannot be lowered further to encourage borrowing and investment, the usual tools of monetary policy lose their power.
4. Step 4: Compare the given options to the definition of a liquidity trap. The correct description should highlight the ineffectiveness of monetary policy due to near-zero interest rates and a preference for liquidity (cash).
5. Step 5: Conclude that the correct answer is the one stating that monetary policy becomes ineffective because interest rates are close to zero and people prefer holding cash rather than investing.