Question

A liquidity trap most likely will occur when (1.06) a) there is a severe recession and interest rates are relatively high b) there is a severe recession and interest rates are relatively low c) there is great prosperity and interest rates are relatively high d) there is great prosperity and interest rates are relatively low

Short answer

A liquidity trap most likely occurs when there is a severe recession and interest rates are relatively low, as presented in scenario b). This is due to people preferring to hoard cash when the incentive to invest or spend is minimal as low-interest rates provide less return on investments, and the expectation of lower interest rates or negative inflation discourages spending.

Step-by-step solution

Identify the conditions for a liquidity trap

Aliquidity trap occurs when interest rates are near zero (or are very low) and people prefer to hold cash instead of investing or spending. This typically happens during a severe recession when monetary policy is ineffective in stimulating economic growth. Step 2: Analyze the given scenarios

Analyze the given scenarios

We have four scenarios to consider; a) a severe recession and high interest rates b) a severe recession and low interest rates c) great prosperity and high interest rates d) great prosperity and low interest rates We need to determine which scenario is most likely to lead to a liquidity trap. Step 3: Compare the scenarios and determine the answer

Compare the scenarios and determine the answer

We can eliminate options c) and d), since they involve great prosperity, which is not the economic condition that leads to a liquidity trap. Now looking at the remaining options - a severe recession with high interest rates (a) and a severe recession with low interest rates (b): While a severe recession is a necessary condition for a liquidity trap, high interest rates (in scenario a) would discourage people from hoarding cash and encourage them to invest or spend. So, this scenario is less likely to lead to a liquidity trap. On the other hand, when interest rates are relatively low (as in scenario b) in a severe recession, people are more likely to hoard cash as they expect even lower interest rates in the future and/or negative inflation, and there is not much incentive to invest or spend. This situation is most likely to lead to a liquidity trap. Hence the correct answer is: b) there is a severe recession and interest rates are relatively low