Japanese Liquidity Trap

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Since the burst of Global financial crisis in 2008, several major world economists presented they concern about world falling into so-called liquidity trap. Even if nobody is certain about the situation in economy these days, many similarities can be found between current economic situation in some developed countries and the case of liquidity trap in 1990´s in Japan. In this paper, I am going to present those parallels and explain some of the dangers that the economy is facing today. I the end, I will discuss the options for escaping from the liquidity trap. What is liquidity trap?

Liquidity trap is a situation in which the short-term nominal interest rates are approaching to zero. This means that asset prices are so high and the rate of return is so low that private sector is expecting drop in prices and growth of interest rates. Expectations of deflation causes that people defer consumption which leads to slack in the economy. The major problem is that central bank already cut policy rates to zero. Therefore the monetary policy ceased to be effective in order to lower interest rates and hence to stimulate economic growth. Because of the negative expectations of economic subjects, even the planned aggregate expenditure is insensitive to changes in interest rates. The economy is in trap. Japan in 1990´s

A typical example of a liquidity trap, which is usually given in courses of macroeconomics, is the situation in Japan during the nineties. The continuing recession associated with strong deflation led the Japanese central bank to a policy of zero interest rates. Even doubling the monetary base didn’t stop the deflation. On the other hand, the fiscal policy recommended by Keynes didn’t bring any major changes either. Au contraire, expansive fiscal policy with a big fiscal deficit led to huge national debt, at the edge of 150 % of GDP. Reason for the prolonged stagnation and deflation is due to policy mistakes and inability to take coordinated action for...
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