Liquidity Trap Japan

JAPAN'S EXPERIENCE OF LIQUIDITY TRAP

The liquidity trap in Japan in the early 1990's, is described by some as representing the lost decade" in Japan's economy. Increased levels of unemployment, price deflation, slow growth and recession all equally contributed to the liquidity problem.

The Central Bank of Japan reacted to the liquidity problem by gradually lowering interest rates in 1991 from 8.3% to approximately zero over an eight-year period to 1999, while remaining at zero for almost a year thereafter. This lowering of interest rates was an effort on the Bank's part to stimulate demand. Furthermore in 1999 bond rates were exceptionally low, the two-year government bond rate being just 0.48% and the corporate bond rate 0.80% (Bank of Japan, 2005)

Japan's woes were ultimately compounded by two factors.

1. The nominal interest rate was approximately zero during the second half of the 1990s. (Bank of Japan 2005)

2. Levels of Deflation in Japan's economy not seen since the Second World War. (Svensson, 2006)

During this period the Central Bank of Japan sought to increase money supply throughout the economy in an effort to counteract the deflation rate and to boost aggregate demand, however these measures while at first were unsuccessful, some albeit minor improvements were noted after a five-year period (Svensson, 2001)

Ineffectiveness of Monetary Policy

The ineffectiveness of the Bank Of Japan's monetary policy in lowering interest rates and increasing the monetary base through conventional and unconventional measures is evidenced given that Japan fell into deeper recession in 1999. Krugman would argue that traditional monetary policy instruments are impotent to provide effective stimulus to the economy and to increase week aggregate demand. This theory first emerged in 1930's when liquidity trap issues were first highlighted during the Great Depression between 1929 and 1933. As interest rates are at the lowest point possible bond-holders would not be inclined to hold zero interest bearing money and as a result spending would be negatively impacted. 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

While the Bank of Japan ended the zero interest rate policy (ZIRP) in August, 2000 inflation was still negative consolidating Japan's liquidity issues with further recessionary woes. This was due to the fact that notwithstanding quantitative easing measures had increased the monetary base by 24% from 1994 to 1997, the overall monetary aggregate grew only by 11%, and credit from banks remained stagnant. Bank Lending in Japan had collapsed in 1998 and money hoarding continued to increase. (Bank of Japan 2005)

Another reason as to why Japan's Monetary Policy was ineffective can be described as the "credit crunch" view. To the fore of this argument is the contraction of the