Question

Which of these statements is the most accurate description of a liquidity trap?

1) Borrowers are willing to borrow, and expansionary policy is used to stimulate the economy as needed.
2) Lenders are willing to lend, but high interest rates keep borrowing slightly lower than needed.
3) Borrowers are unwilling to borrow, and lenders are unwilling to lend due to pessimism about the future.
4) Lenders are willing to lend, but borrowers borrow too much due to increased optimism about the future.

Answer 1

A liquidity trap is a situation where borrowers and lenders are unwilling to engage due to pessimism about the future, rendering monetary policy measures ineffective. The correct option is 3.

Step-by-step explanation:

The most accurate description of a liquidity trap is that it is a situation where monetary policy becomes ineffective. This occurs when interest rates are so low that people prefer to hold onto cash rather than invest in securities with negligible or negative returns. Accordingly, among the options provided, the third statement is the most accurate: Borrowers are unwilling to borrow, and lenders are unwilling to lend due to pessimism about the future. In a liquidity trap, even with expansionary monetary policy that attempts to lower interest rates to stimulate the economy, consumers and businesses may still hold back on borrowing and spending due to economic uncertainty, rendering policy measures ineffective.

A liquidity trap occurs when interest rates are very low, and monetary policy is unable to stimulate borrowing and spending in the economy. In this situation, individuals and businesses are hesitant to take on additional debt or invest due to concerns about the future economic outlook.