Liquidity Trap In Japan

2008 Icfai Business School Group B Section C

For: Prof Joy Choudhary BY: Rahul chandalia Poonam agarwal Priyanka agarwal Gagan deep Ajay Dogra Shruti Toshniwal

[LIQUIDITY TRAP IN JAPAN] Using the Keynes IS-LM model explain the Liquidity trap in Japan in the early 90’s

Q. Using the ISLM model explain the liquidity trap in Japan? Q. Find out the Equilibrium output at that point? Q. What policy measures were taken? -----------------------------------------------------------------------------------------------------------

Liquidity Trap: A situation in which an increase in the money supply does not result in a fall in the interest rates bur merely in an addition to idle balances A’ the interest elasticity of demand for money becomes infinite.

What happened in Japan? 1. The economy was in trap of liquidity because the aggregate demands of the entire

economy continuously showed a down trend despite a very low or zero interest rate. 2. Speculative asset price bubble collapsed in 1990’s 3. The market participants believed that interest rates have reached bottom, thus any

further injunction of money lead to the increase in holding of idle cash. 4.

The short-term real interest rate that would be needed to match saving and investment was negative; since nominal interest rates cannot be negative, the country therefore needed expected inflation.

5. Production capacity was working below optimum utilization 6. Economy lacked real growth 7. Gradually declining GDP growth

A few evidences of the falling short term interest rates in Japan as compared to other countries and the Deflation rates as compared to other countries have been presented below.

Causes of the liquidity trap in Japan 1. Expected future productive capacity being lower than current 2. Predominantly high rate of savings 3. Too much corporate debt 4. Refusal of banks to face up their losses

5. Overregulation of service sector 6. Ageing of the population

7. Recovery requiring tax cuts 8. Massive bank reforms 9. Structural deficiencies

Although several reasons have been put forward to explain the sustained weakness of the Japanese economy, none is more intriguing from the viewpoint of a central bank than the possibility that monetary policy had been largely ineffective because the Japanese economy entered a Keynesian "liquidity trap." The economy was in a liquidity trap as aggregate demand consistently fell short of productive capacity despite essentially zero short-term nominal interest rates. Japan certainly more or less met the interest-rate criterion, the overnight moneymarket rate was 0.37 percent. The economy also certainly seems to be operating well below capacity. The high savings habit supplied needed capital to private investors in form of bank loans and other sources. This ensured a superfluous growth rate in normal times. But in time of the great depression this boon turned into bane for Japan as it caused a severe slump in the aggregate demand.

The real interest rate was negative but the nominal interest rate cannot go negative because then bonds would become assets instead of liability. This caused in pile up of corporate debt and banks were unable to liquefy these assets. Even the political will made it evident for the economy to fall. The lack of political will and mistakes in taking regulatory measures lead to in decent interest rate cuts and tax impositions. The Equilibrium output: In view of the lowest interest rates the equilibrium point can be assessed as where on the LM curve, the IS curve intersects. That point ‘X’ depicted below in the figure signifies the equilibrium position. The point corresponding to X on the vertical axis is the “rate of interest’ and on the horizontal axis is the equilibrium output.

X

Equilibrium Output

Measures taken: In view of a committee set up by the International Monetary Fund the recessionary situations in Japan could have been dealt up with a series of long term measures. Those measures have been stated below intact:

Suggested Measures:

In view of these adverse consequences, the first principle was to avoid the deflationary spiral itself and this can be done by having an inflation target 'consistently on the high side of zero'. Central banks had, therefore, generally adopted inflation targets - whether implicit or explicit - of around two per cent. Furthermore, central banks and fiscal authorities prepared for the worst and accordingly make advance contingency plans for a series of emergency measures. These measures were: •

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In an environment of low inflation, central banks should take sufficient insurance against downside risks through a precautionary easing of monetary policy. Easing of fiscal policy to boost domestic demand. Open market purchases of long-term bonds (which would re inflate asset prices through portfolio rebalancing and the expectations channel and enable reduction in external finance premium), and, if need be, more unorthodox open market interventions in corporate bonds, property and stocks. Increase inflation expectations, i.e., ‘credibly promise to be irresponsible’. Depreciation of the exchange rate coupled with a price level target path. Carry-tax on money (both reserve balances and currency) in order to lower short-term rates significantly below zero; an occasional carry-tax could be superior to perennially incurring a positive inflation rate. However, the possibility of currency substitution could weaken the efficacy of a tax on currency.

A stylized fact in regard to inflation is that it is highly persistent, i.e., if there is a shock that raises inflation today, inflation continues to remain high in the future and vice versa. High persistence (a unit root) indicates that inflation expectations are not well-anchored and policy efforts to reduce inflation will have to bear significant output losses. In this context, increased transparency in monetary policy formulation with priority to price stability as a key objective is expected to provide an anchor to inflation expectations and hence lower the persistence of inflation. This has an important implication: any future shock that raises inflation temporarily will not lead to a permanent rise in inflation expectations and actual inflation