One situation in which the market does not function as usual is the so-called liquidity trap. Here, interest rates are so low that it is not possible to expand the money supply by lowering interest rates. The graphic illustrates this in the IS-LM model. In the normal situation, the LM curve slopes upwards at the equilibrium point GG (intersection IS and LM). In the liquidity trap, however, IS and LM curve intersect at a flat spot of the LM curve. This situation can occur if, for example
- the IS curve is shifted so far to the left due to a crisis (e.g. economic slump, decrease of domestic demand, decrease of export demand, cuts by the government, austerity policy, ...) or
- due to very expansive monetary policy (e.g. to avert an economic crisis, etc.) the LM curve is shifted so far to the right.
If the shift is caused by an expansive monetary policy, it ends as soon as the intersection reaches the flat part of the LM curve, usually when the interest rate is 0. In order to increase the money supply even further, exceptional measures must be taken: "quantitative easing".
This phenomenon was first economically analyzed and named by John Maynard Keynes. He described the liquidity trap as a state of the economy in which an expansion of the money supply does not lead to a decrease of the interest rates, i.e. the causality of interest rate and money supply is viewed inversely. Keynes presents an economy in an equilibrium at underemployment and depicts the situation between the world wars. He propagates expansive fiscal and monetary policy without having to fear crowding-out or interest rate increases (investment decline). Rather, such fiscal policy measures act as an initial spark, as they have a major impact thanks to the multiplier effect, while monetary policy measures end up in the liquidity trap.