Deflation can lead to a liquidity trap because which mechanism?

• A. It reduces real debt burden
• B. It increases real interest rates and can hamper borrowing
• C. It lowers real interest rates
• D. It stimulates demand

Answer: (B)

Deflation creates a liquidity trap because it raises the real cost of borrowing. When prices fall, the inflation rate is negative, so the real interest rate (roughly a nominal rate minus inflation) stays high or becomes positive even if the central bank lowers nominal rates toward zero. With higher real rates, households and firms are less inclined to borrow and spend, so monetary stimulus has little effect. This is why deflation can lock an economy into a stagnating path: the mechanism is that deflation raises real interest rates and hampers borrowing.