How come inflation does NOT increase if the money supply increases during a liqu

Question

How come inflation does NOT increase if the money supply increases during a liquidity trap? My guess is that if people hold more cash, they would spend more. Given that during a liquidity trap the economy is maxed out and cannot increase output, the extra influx of spending would only serve as to increasing prices. Apparently this is not the case. What happens to the influx of cash? Do people simply hold it? EDIT: I found this, but it doesn't really make sense to me. "Conventionally, the expansion of the money supply will generate inflation as more money is chasing after the same amount of goods available. During a liquidity trap, however, increases in money supply are fully absorbed by excess demand for money (liquidity); investors hoard the increased money instead of spending it because the opportunity cost of holding cash—the forgone earnings from interest—is zero when the nominal interest rate is zero. Even worse, if the increased money supply is through LSAPs on long-term debts (as is the case under QE), investors are prompted to further shift their portfolio holdings from interest-bearing assets to cash."

Explanation / Answer

You're right when they say that people will spend more when they hold the cash but the multiplier effect of this increase in money supply is felt through debt creation also. In a liquidity trap, the deposit interest rate hover around 0 due to which the holder of cash have no incentive to lock their money with bank. This makes it difficult for banks to lend money. As a result, the business and consumer spending suffer as they don't need to borrow from banks.

What happens to the influx of cash?
Yes, people just hold it as they have no incentive to deposit money with bank due to really low interest rates.

To understand what you have quoted, you must understand what is meant by demand for money in economics. It comprises of both transaction demand (kY) and speculative demand (hi).

L = kY - hi,

where Y is output and i is interest rate. the coefficients measure the sensitivity.

Essentially, when i is close to 0, then there is no speculative demand for money and the demand for money (liquidity) is only determined by kY i.e. transaction demand.

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