Japan has experienced stagnation, deflation, and low interest rates for decades. Even the attitude of the financial regulator and government administrators is reminiscent of the days when japan was slipping into a sort of longterm liquidity trap in the early nineties. Some commentators have tried to revitalize the old keynesian idea of the liquidity trap. Signature characteristics of a liquidity trap are shortterm interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels. Japan s economy has stagnated since the bursting of its economic bubble. Japan s economy provides a good example of a liquidity trap. The authors institutional affiliation is provided solely for identification purposes. A liquidity trap is characterized by a situationsimilar to japan todaywhere interest rates. Overcoming japans liquidity trap linkedin slideshare. This paper provides evidence on whether the japanese economy entered a liquidity trap in the recent period, based on a money demand framework. Ken rogoff, in 1998 discussion of krugman 1998 analysis of japan. Monetary policy in a liquidity trap the views expressed here are those of the author and do not necessarily represent the views of the federal reserve bank of philadelphia or the federal reserve system. The current subprime mortgage crises and its effect on the us financial system, yet to fully manifest, is probably the first serious indicator of the fact. Data are provided which question both analogies and policy advice based on them.
Japan is the first major industrial economy to face serious deflation since the 1930s, and, not surprisingly, that also was the time that the liquidity trap explanation for the ineffectiveness of monetary policy was popularized. We use the model to study the consequences of alternative monetary policies following a tightening in the collateral requirement. Japan and the liquidity trap in my last post, i claimed that the main theoretical framework that people use to think about the japanese stagnation the mainstream woodford new keynesian model and its baby brother the econ 102 adas model didnt apply, because prices couldnt be. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Japan s trap paul krugman may 1998 japan s economic malaise is first and foremost a problem for japan itself. Some previous studies addressed the issue of a liquidity trap in japan and investigated it empirically in one way or another. This paper examines japans liquidity trap in light of different strands in the theoretical literature. Nobelprize winning economist paul krugman says it has now spread to some emerging markets as well.
Paul krugman says the liquidity trap has spread to. Japan their analysis, and almost all subsequent analysis of the liquidity trap, ignored foreign trade and capital mobility. Liquidity trap s and the stability of money demand. A liquidity trap occurs when people dont spend or invest even when interest rates are low. In fact, japan has not been been in such a trap in the years following 1990, and the whole idea of the trap. A liquidity trap may be defined as a situation in which conventional. A liquidity trap is a situation in which monetary policy becomes ine. The goal is to stimulate spending by making borrowing cheaper and. The liquidity trap is the inability of a central bank to stimulate economic growth through interest rate cuts. Bank of japan operations that purchase private equities, aside from the political problems involved, yield. Consequently, in assessments of policy alternatives in a liquidity trap, the focus should be on how e. In this article we will discuss about the concept of liquidity trap, explained with the help of a suitable diagram. Japan is in the dreaded liquidity trap, in which monetary policy becomes ineffective because you cant push. Conventional monetary policy ineffectiveness liquidity.
In this paper we estimate longrun money demand for japan with two functional forms that allow for the liquidity trap, and compare the empirical results for these. What a liquidity trap is and why were looking at one. Krugman 141 of its history, japan is now in a liquidity trap, so that the generic issues surrounding such traps apply. The liquidity trap that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant because. See svensson 2001 and eggertsson and woodford 2003 for discussion and references. Last spring i argued, in an essay entitled japan s trap, that the natural answer to japan s liquidity trap is a deliberate, announced policy of moderate inflation and that monetary policy is ineffective precisely because the private sector expects the bank of japan to behave responsibly, so that current monetary expansion does not change expectations about future price. The case for openmarket purchases in a liquidity trap. Japans trap paul krugman may 1998 japans economic malaise. For example, hondroyiannis, swany, and tavlas 2000 showed that the absolute value of the. It is useful, in considering japans liquidity trap, to begin at a high level of generality, to adopt what one might. One thing that i find very interesting about paul krugmans analysis of the liquidity trap and fiscal policy back in 1999 is how very closely it tracks ken rogoffs analysis of the liquidity trap and fiscal policy today.
Our empirical analysis challenges the beliefs of some western economists, such as paul krugman, that the japanese economy is in liquidity trap. The liquidity trap and negative natural interest rate. The theoretical analysis of japan s liquidity trap is developed by krugman 1998a,b,c. This paper examines the effects of a moneyfinanced fiscal expansion a helicopter dropwhen an economy is in a. But once it became clear that the bank of japan really did consider itself unable to increase demand in an economy that badly needed it, it also became clear to me at least that the theory of the liquidity trap. A liquidity trap is a situation, described in keynesian economics, in which, after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest. Hicks islm analysis, the basic idea is borrowed from j. The author thanks various seminar participants, prof. The international dependence of the optimal monetary policy discussed in this paper is a new feature of interdependence that arises in a global liquidity trap. This paper examines japans liquidity trap in light of the structure and performance of the countrys economy since the onset of stagnation. Japan s economy was the envy of the world in the 1980sit grew at an average annual rate as measured by gdp of 3. The liquidity trap that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant because money and bonds are essentially perfect substitutes played a central role in. Japan is in a liquidity trapa situation when the zero lower bound for the instrument rate zlb is strictly binding, in the sense that it prevents the central bank from. A markov regimeswitching approach is also used to determine whether the more recent response of money demand to interest rates can be characterized into a separate regime.
Therefore, monetary policy alternatives in a liquidity trap should be assessed according to how effective they are likely to be in. Monetary policy in a liquidity trap the new york times. Since the early 1990s the japanese economy has been su. Liquidity trap refers to a situation in which an increase in the money supply does not result in a fall in the interest rate but merely in an addition to idle balances. Monetary policy and japans liquidity trap ideasrepec. Japan has effectively been in a liquidity trap, with policy rates very near zero, and now below it, since 1996, as shown in the. The story of selffulfilling pessimism is a multiple equilibrium story. The socalled liquidity trap, when monetary policy loses its traction as interest rates get close to zero, has plagued rich countries for years. Monetary policy in a liquidity trap april 11, 20 7. Japans liquidity trap abstract japan has experienced stagnation, deflation and low interest rates for decades. As inflationary monetary economics and liquidity traps come into focus with zerointerest rate policy or even negative interest rate policy spreading throughout the world, many are looking to. Liquidity trap definition and example investopedia. Krugman says the liquidity trap spread to emerging markets.
This paper examines japans liquidity trap in light of the structure and. This paper examines japan s liquidity trap in light of the structure and performance of the countrys economy since the onset of stagnation. The liquidity trap is the situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective. In open economies, countries are naturally interrelated through trades in goods and services. The great recession of 20082009 was compared with the great depression and the prolonged stagnation in japan, attributed to a liquidity trap.
A liquidity trap is caused when people hoard cash because they expect an adverse. If it goes on long enough it could lead to deflation. In the early years of macroeconomics as a discipline, the liquidity trap that awkward condition. For example, one can feel quite confident that if the boj were to issue a 25 percent increase in the current supply and use it to buy back 4 percent of government nominal debt, inflationary expectations would rise. It is the firstbest policy to end stagnation and deflation in japan. Paul krugman says the liquidity trap has spread to emerging markets. The central bank cant boost the economy because there is no demand. Managing a credit crunch francisco buera juan pablo nicolini z june 11, 20 abstract we present a model of a monetary economy with heterogeneous producers and collateral constraints.
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