Liquidity Trap

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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. A liquidity trap is characterized by a situation--similar to Japan today--where interest rates are at or near zero. Monetary policy is seemingly impotent to stimulate demand and raise spending since interest rates are already at the lowest point possible--no one would normally be willing to hold bonds with negative yields over (zero interest-bearing) money.

Is Japan in a liquidity trap? Krugman (1998a) forcefully argues this case and suggests a specific and unorthodox policy recommendation--that the BOJ bring inflation and inflationary expectations up to 4% and keep them there for 15 years (see Spiegel 2000). The key element of Krugman's analysis is that the equilibrium real interest rate--that is, the real rate that would match saving and investment--is negative in a liquidity trap. How could the equilibrium real interest rate be negative? Because poor long-run growth prospects, which, in Japan's case, presumably are linked to unfavorable demographic trends, make investment demand so low that a negative short-term real interest rate would be needed to match saving with investment. Given a nominal interest rate floor of zero, Krugman argues that a positive expected rate of inflation is necessary to generate negative real interest rates, which will stimulate aggregate demand and restore full employment.

Krugman draws on two bits of empirical evidence to support the liquidity trap argument. First, he points to the fact that short-term interest rates have reached a minimum point, virtually zero. Moreover, the yield curve has been virtually flat, as the 10-year government ...