Krista McWhinnie January 28, 2005
When an economy is suﬀering a recession, and the attempts of conventional monetary
policy to stimulate aggregate demand become futile, this economy is said to have fallen into the dreaded ”liquidity trap.” In such a trap, monetary policy proves ineﬀective due to the fact that the nominal interest rate has reached its lower bound of zero. The second largest economy in the world is said to have been caught in this liquidity trap since the early 1990’s. A broad spectrum of thinking exists on the causes of, and possible escapes from, the Japanese liquidity trap.
What is a Liquidity Trap?
When the forecasts of a central bank indicate recession and low levels of inﬂation, the
correct response is to use monetary policy to lower the nominal interest rate. Such a policy should reduce the real interest rate, increasing investment and thus, aggregate demand. However, when the nominal interest rate is low to begin with, the central bank may not have much room to drop the interest rate further. The key to the liquidity trap lies in the fact that the nominal interest rate is subject to a lower bound at, or slightly above, zero. Any lower rate would imply that lenders might pay a borrower to borrow – an obviously nonsensical idea. With interest rates close to zero, monetary policy is rendered powerless, and the economy ﬁnds itself caught in a liquidity
trap where the real interest rate required to equate savings with investment is negative. A liquidity trap, combined with low inﬂation or even deﬂation, can send the economy on a downward spiral into a prolonged recession.
The Japanese Liquidity Trap
Japan’s recent experience moves the theoretical warnings of a liquidity trap into the realm
of reality. Since the early 1990’s the Japanese economy has been suﬀering conditions that seem to resemble those of a liquidity trap. The collapse of the bubble economy in the early 1990’s ended a two-decade era of highly impressive economic growth in Japan. From the 1960’s through the 1980’s the Japanese economy achieved one of the highest economic growth rates in the world; however, by 1990 this encouraging growth slowed radically. Growth in Japan over the last decade has been slower than growth in other major industrial nations, and it has been several decades since any major industrial country has experienced interest rates as low as those seen in Japan at the end of the 1990’s. This period, characterized by ﬂoor level interest rates, the Bank of Japan’s inability to stimulate aggregate demand through expansionary monetary policy, and consistent performance below capacity, has been named ”Japan’s Liquidity Trap.” Two interesting questions emerge from the recent Japanese experience: how did Japan arrive in the liquidity trap, and how might it escape?
How did Japan get Trapped?
Proponents of the liquidity trap theory have made a good case that Japan is indeed
caught in this trap, but have diﬃculty explaining exactly why they have fallen victim to this economic ill. The chief explanations focus largely on demographic trends. Liquidity trap theory claims that a trap may arise when current productive capacity is actually greater than future capacity. Japan’s demographic trends of a declining birth rate combined with a lack of
immigration certainly indicate why Japan’s future capacity might be low relative to current capacity. Demography also aﬀects investment demand: the expected future reduction in the labour force decreases the expected return on investments. Other explanations of the trap point to capital market ineﬃciencies and institutional peculiarities within Japan.
Escaping from the Liquidity Trap
There has been no shortage of advice oﬀered to the Japanese government on how to get
out of the trap. The escape strategies fall into three broad categories: structural reform, ﬁscal expansion and, most...