The production of goods and services gives rise to income that is devoted to either the purchase of consumer goods and services or saving which is equal to investment spending. This notion leads us to the fact that the aggregate demand and the aggregate supply will be in equilibrium. This way, rationally, it’s easy to understand the assumption that under standard economic theory, an economy should not face a problem of insufficient aggregate demand.
Although theoretically no economy should be faced with a problem of this nature, in the real world it may not happen like this. One specific reason for the aggregate demand to be behave insufficiently was a phenomenon inherent to the Great Depression, denominated as “Liquidity Trap”. This singularity implies that the central bank is incapable of expanding aggregate demand, this is, if an expansion in the money supply is not followed by a decrease in the interest rate, it means that the central bank is impotent as to influence consumption and investment. It also implies that a decline the price level (followed by an increase in real money balance) does not mean that the demand for goods and services will increase.
In a liquidity trap, consumers prefer to keep their funds in savings rather than investing in bonds because of the prevailing belief that interest rates will soon rise. Given that there is an inverse relation between the price of a bond and the interest rate, the majority of the consumers don’t see as desirable to possess an asset whose price is expected to decline.
Japan’s current economic situation is a viable example of the phenomenon in question. For a couple of decades now, some of the most important economic indicators of this country have been proved to be in a delicate condition: nominal GDP has been stagnant for almost 25 years; real GDP has been essentially flat since the mid-1990s; nominal short-term interest rates have been close to zero; nominal long-term interest rates, as measured by the yields of Japanese government bonds, have also been extremely low for many years, while the Bank of Japan’s monetary policy has been highly accommodative for decades.
Japan seems to be caught in an economic and financial situation incapable of reviving growth, given the accommodative monetary policy in practice, portrayed by low nominal interest rates and an elevated balance sheet of the central bank. The fact that monetary easing has been unable to overcome deflationary trends, combined with the fact that gross domestic business fixed investment has not responded favourably to low nominal interest rates, come to corroborate the idea that the central bank has become unable to influence consumption and investment through monetary policy.
Japan’s economy was, arguably, the most powerful in the world in the 1980s, in which it grew at an average annual rate, as measured by the GDP, of 3,89% when compared to 3,07% in the United States. However, Japan’s economy fell into a hole in the 1990s. From 1991 to 2003, the country’s economy grew only 1,14% annually, way below when compared to the other economic potencies in the world.
Starting in the fall of 1989, Japan’s equity and real estate bubbles burst. Equity values plunged 60% from late 1989 to August 1992, while land values dropped throughout the 1990s, falling an incredible 70% by 2001.
This events required an efficient intervention by the country’s central bank, but in reality, it’s highly acknowledged that several mistakes were made when treating this sensitive situation: the Bank of Japan, concerned about inflation and asset prices, decreased the money supply in 1980s, which may have contributed to the bursting of the bubble; then, because the value of equities continued to go down, the Bank of Japan kept increasing the interest rates since there was still concern about real estate values, which continued to appreciate; these higher interest rates contributed to the end of increasing land prices, but also resulted in the overall economy slide into a downward spiral. With these procedures, in 1991, as equity and land prices fell, the Bank of Japan dramatically reversed the strategy and started to decrease interest rates, which revealed to be too late as the liquidity trap was already in place, and credit crunch was already setting in.
In 2001, the Bank of Japan instead of targeting interest rates, began to aim at the money supply, which helped moderating deflation and stimulating economic growth. However, when a central bank injects money into the financial system, banks are left with more money in its possession which implies that they must be willing to lend that money out. This lead to another problem in Japan’s economy, the credit crunch, which has been highly regarded as the main reason for the ineffectiveness of monetary policy.
This phenomenon of credit crunch is an economic scenario in which banks have tightened lending requirements and for the most part, do not lend. One of the reasons for not lending is the need to hold onto reserves in order to repair their balance sheets after suffering losses, which happened to Japanese banks that had invested strongly in real estate. When banks are reluctant to lend, it’s difficult for the economy to grow. In the same manner that a liquidity trap leads to deflation, a credit crunch is also conductive to deflation as banks are unwilling to lend and, therefore, consumers and businesses are unable to spend, causing prices to fall.
Having said this, it’s easy to conclude that deflation causes lots of problems. When asset prices are falling, households and investors hoard cash because it will be worth more tomorrow that it does today. This leads to the creation of a liquidity trap. When asset prices fall, the value of collateral backing loans falls, which in turn results in bank losses. When banks suffer losses, they stop lending, creating a credit crunch. Most of the time, we consider inflation as a very troubled economic problem, which it can be, but re-inflating an economy might be precisely what is needed to avoid prolonged periods of slow growth such as the one Japan experienced in the 1990s. However, re-inflating an economy isn’t easy, especially when banks are unwilling to lend.
Finally, it’s important to analyse some important solutions advocated by the mainstream economists. Krugman and Bernanke support solutions to this problem that ultimately rest on the quantity theory of money. These solutions consist of making a trustworthy commitment to a constant increase in money supply and the expansion of the central bank’s balance sheet. Following this point of view, the concern for the central banks must be inherent with an increase in inflation expectations into perpetuity, primarily through increasing high-powered money with the expansion of the central bank’s balance sheet. This solution implicitly assumes that monetary accommodation would eventually lead to higher expectations of inflation and induce risk taking due to the effect of an increased monetary stock on aggregate demand, in such view that the nominal interest rate should be lowered as much as possible, thus inducing investment and consumer spending. However, if the nominal interest rate cannot be lowered beyond some lower bound, then the central bank must engage in the purchase of long-duration assets and therefore reduce long-term interest rates. Krugman’s main policy proposal for when a given economy is trapped in such phenomenon is for the central bank to credibly promise “to print more money in the future, when the zero lower bound no longer binds”.
For both these economists, it’s “simple”: get the central bank to credibly commit to produce inflation. This because they blame the Bank of Japan of not being able to pursue the right paths in order to create inflation and reset inflationary expectations among the public and investors. In their point of view, the Bank of Japan lacked credibility. Paraphrasing Krugman, “if monetary expansion does not work it must be because the public does not expect it to be sustained”. The Japanese economy cannot get out of the liquidity trap because the real interest rate stays high, as the central bank’s failure to credibly commit to monetary expansion means that inflation and inflation expectations stay low or that deflationary pressures persist.
 Tanweer Akram (2016), Thrivent Financial. Japan’s Liquidity Trap.
 Krugman, Paul (2000) Thinking About the Liquidity Trap. Journal of the Japanese and International Economies.
 Krugman, Paul. (1998). ‘‘It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap.’’ Brookings Papers on Economic Activity.
 Krugman, Paul. 1998b. “Japan: Still Trapped?”
 Spiegel, Mark. 2000. “Inflation Targeting for the Bank of Japan?” FRBSF Economic Letter2000-11
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