a. Which situations correspond to a liquidity trap as defined in Chapter 4? b. W
ID: 1143971 • Letter: A
Question
a. Which situations correspond to a liquidity trap as defined
in Chapter 4?
b. Which situations correspond to the case where the nominal
policy interest rate is at the Zero Lower Bound?
c. Which situation has the highest risk premium? What two
factors in bond markets lead to a positive risk premium?
d. Why is it so important when the nominal policy interest
rate is at the Zero Lower Bound to maintain a positive expected
rate of inflation?
|policy |inflation policy premium!borrowing!borrowing interest interest interestinterest co rate A3 B 4 C O rate CD 4 ER 3 E 0 2Explanation / Answer
(a.) situation E corresponds to a liquidity trap as defined in chapter 4 because the inflation rate of situation E is low among all the other situations .
(b.) situations C and situation E corresponds to the case where the nominal policiy interest rate is at the Zero Lower Bound as the interest rates of situations C and E reaches or nears zero, and cannot lower it further
(c.) situation A has the highest risk premium because this situation has riskless rate of interest.Expected inflation and liquidity are the two factors in bond markets lead to positive risk premium.
(d.) It is important when the nominal policy interest rate is at the Zero Lower Bound to maintain a positive expected rate of inflation because the Zero Lower Bound refers to a situation in which the short-term nominal interest rate is zero, or just above zero, causing a liquidity trap and limiting the capacity that the central bank has to stimulate economic growth.
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