One such inherent problem which dilutes the effectiveness of interest rates as a viable monetary policy instrument is a liquidity trap situation.
Liquidity trap is a situation when the rate of interest falls too low to be used as a monetary policy tool. It is a situation when the nominal rate of interest becomes so close to zero so that the real rate of interest could almost be considered as negligible. The lower the rate of interest is higher is the amount of aggregate investment expected to be; but the problem in this instance is that commercial banks do not have ample funds to lend out to the investors. Hence, there are little chances of any stimulation in the aggregate level of investment and so of that of the aggregate output in the economy. Usually, the need for lowering the rate of interest arises when the nation in question is in an urgent need of financial stimulation. However, if the nominal rate of interest is already bound to zero and there is practically no room left for further depreciation, the multiplicative impact of an expansionary monetary policy goes in vain (Rabin, 2004).
The LM curve diagram being depicted here shows that till the point when the rate of interest lingers above Rt, there are possibilities of the rate of interest being used as an effective expansionary monetary policy measure. However, at Rt, when the shape of the LM curve becomes almost horizontal, changes in aggregate demand for money from Ma to Mb and vice-versa, has no mushrooming impact at all. Hence, in such a situation, the stimulating power of rate of interest becomes almost zero. Quite obviously, the economy has to rely upon other measures to invigorate the financial condition in the economy and also initiate some steps to reinstate the corrective power of the rate of interest.
Hence, unless there is a fall in the rate of interest there are little chances of an appreciation in the aggregate output level in the current period and