Question

Which situations correspond to a liquidity trap as defined in chapter 4?

Option 1: High interest rates leading to increased savings.
Option 2: Low interest rates causing a surge in investment.
Option 3: Increased consumer spending due to low interest rates.
Option 4: Hoarding of money despite low interest rates.

Answer 1

A liquidity trap occurs when people hoard money despite low interest rates, with expectations of deflation reinforcing this behavior by making cash more attractive compared to spending or investing.

Step-by-step explanation:

The situation that corresponds to a liquidity trap as defined in chapter 4 is Option 4: Hoarding of money despite low interest rates. A liquidity trap is a condition where monetary policy becomes ineffective because people prefer to hold onto cash instead of investing or spending it, regardless of how low the interest rates are. This scenario is reinforced by expectations of deflation, meaning that consumers expect prices to fall, which makes cash hold a positive real interest rate and discourages spending or investment in the economy.