The Liquidity Trap Theory and Japan’s Economy
ABSTRACT
The Japanese economy has undergone stagnation, inflation and low interest rates for a
number of decades and has been caught in a liquidity trap at some points. This paper aims to
evaluate the economy’s liquidity trap while being mindful of the structure and economic
performances. It is herein contended that the Keynesian perspective and Krugman’s insights
are still relevant as the Keynesian perspective aids the understanding of a country’s liquidity
trap as well as devising and effecting policies that could potentially help overcome this and
promote renewed economic development and growth.
Risk of low inflation and deflation rates have been identified as the main causes of liquidity
traps by Paul Krugman and Ben Bernanke. Accordingly, it has been suggested by them that
central banks should make a trustworthy commitment to sustain monetary easing as the key
to reigniting inflation which would allow for an escape from this trap by virtue of low interest
rates and quantitative easing. On the contrary, John Maynard Keynes assumes that the
probability of a liquidity trap arises due to a sharp rise in investors’ liquidity preference and
the anxiety regarding capital losses which come about due to the uncertainty about the
bearing of interest rates. Accordingly, he advocated for an integrated strategy so as to
alleviate the repercussions. This integrated strategy thereby consists of robust fiscal policy
and boosting employment which would lead to the creation of a higher expected marginal
efficiency of capital, while the central bank stabilises the yield curve and reduces interest rate
unpredictability to lessen investors’ expectancies of capital loss.
INTRODUCTION
According to the Keynesian school of thought, the ability of a monetary policy to promote
economic activity by driving down interest rates may be compromised by the occurrence of a
liquidity trap.1 This phenomenon is described as a situation wherein the interest rate has
fallen to a certain level such that liquidity preferences could potentially become absolute in
the sense that people would prefer holding cash rather than investing which provides a low
1
Grandmont, Jean-Michel, and Guy Laroque. “The Liquidity Trap.” Econometrica, vol. 44, no. 1, 1976, pp.
129–135. JSTOR, JSTOR, www.jstor.org/stable/1911386.
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rate of interest.2 Essentially, it is a situation where people begin to store cash based on their
expectation of an adverse event such as deflation, insufficient aggregate demand etc.
“Liquidity Trap” describes a special property of demand for money which is supposed to
increase in an unlimited fashion as long as the long-term interest rate declines to zero. It has
been argued by some economists that this situation will be prevalent even when the interest
rate reaches a low, however, positive level.3
As per the standard economic theory, an economy should not experience a problem of
insufficient demand – this view is regarded as Say’s Law. Consequently so, aggregate supply
and aggregate demand must be in equilibrium. The basis of this is the idea that production
and sale of commodities will generate income which will either be saved or consumed. The
amount that is saved will then be spent on investment. Essentially, the production of
commodities will raise income that is either devoted to either purchasing commodities or
saving that is equal to investment. Subsequently, no problem arises when aggregate demand
is less than aggregate supply.4
Keynes furthers Malthus’ critique of Say’s Law in The General Theory. According to
Keynes, there is an intrinsic problem in the modern capitalist economy that can experience
shortfalls on aggregate demand, regardless of the time period and gravity, due to which the
level of employment will always remain below the maximum potential level of employment.
In such an economy, speculators have a disposition towards liquidity as a result of the
fundamental uncertainty regarding what the future holds. Psychological and social factors
also play an important role in the speculators’ predilection. They may keep cash at hand or
hold other types of financial assets as a store of value as a result of which savings may not be
invested. Consequently, the economy will not attain full employment. Changes in interest
rates may not be enough to effect investment and reach the goal of full employment.5
EXISTENCE OF LIQUIDITY TRAPS
Predominantly, the existence of liquidity traps is based on two theories. Primarily, when
interest rates are at a low and declining rate in an economy, there is an expectation that the
Keynes, John Maynard. “The General Theory of Employment, Interest and Money”. United Kingdom:
Palgrave Macmillan, 2007 edition, ISBN 978-0-230-00476-4
3
Grandmont, Jean-Michel, and Guy Laroque. “The Liquidity Trap.” Econometrica, vol. 44, no. 1, 1976, pp.
129–135. JSTOR, JSTOR, www.jstor.org/stable/1911386.
4
Baumol, William J. “Say's (at Least) Eight Laws, or What Say and James Mill May Really Have
Meant.” Economica, vol. 44, no. 174, 1977, pp. 145–161. JSTOR, JSTOR, www.jstor.org/stable/2553717.
2
5
Sowell, Thomas. Say's Law: An Historical Analysis. Princeton University Press, 1972. JSTOR,
www.jstor.org/stable/j.ctt13x0w9s.
2
interest rate will cease to fall but rather it would begin to rise. Due to this rise, capital losses
will accumulate for those who sell bonds and those who hold cash will obtain increased
earnings. Therefore, in order to avoid the former and pursue the latter, speculators would
much rather hold money as cash than invest. At some low interest rate, the demand for
money would be perfectly elastic. This is known as the expectation argument.
The latter argues that at any given interest rate, some people would hold onto cash rather than
invest as “the trouble of making a transaction may offset the gain in interest.”6 The number of
people unwilling to invest and the interest rate have an inversely proportional relationship:
the lower the interest rate, the greater the number of people who would want to keep cash at
hand. Ostensibly, there is a particular positive rate at which all individuals would rather not
invest – at this rate, the demand for money becomes perfectly elastic. This is known as the
cost of acquiring bonds argument.
CRITIQUE OF THE LIQUIDITY TRAP THEORY
In the General Theory, Keynes provided for three types of traps – weak, strong and extreme.
Under the weak version, elasticity of liquidity preference becomes considerably high at low
levels of interest, it does not become infinite. In the strong version, liquidity preference is
perfectly elastic in a finite segment. In the extreme case, the rate of interest cannot be reduced
by increasing money supply in the economy. The weak version cannot be classified as a true
trap since the equilibrium interest rate can be lowered by implementing appropriate monetary
supply tools. Empirical investigations have shown that the weak version of the trap has very
little practical significance.7
JAPAN: MACROECONOMIC SCENARIO AND LIQUIDITY TRAP
Japan’s economy plunged into stagnation and experienced price deflation after the bubble
economy broke down in 1991 up till 2001. Due to this, the Japanese economy went through
periods of near zero growth which was quite a drastic change in comparison to its previous 4
percent growth in the 1980s. The nation’s GDP growth fell to less than half its rate of 3.89%
(during the 1980s) to 1.14% (post 1991). One of the major reasons for this occurrence was
that its equity ad real estate bubble began to decline in wherein values plunged by 70% by
Hicks, J. R. “Value and Capital” Oxford University Press, 2 nd ed., 1946, pp 164-165
Beranek, William, and Richard H. Timberlake. “The Liquidity Trap Theory: A Critique.” Southern Economic
Journal, vol. 54, no. 2, 1987, pp. 387–396. JSTOR, JSTOR, www.jstor.org/stable/1059323.
6
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2001.8 To add to this, Japan’s central bank may have made some mistakes that could have
prolonged its effect and made matters worse. This was known as “Japan’s Lost Decade.”9
Japan’s industrial productions slowed down during the 1990s to early 2000s and after the
2001 recession, it improved moderately. However, it took a plunge during the Global
Financial Crisis of 2007-08. This caused a slowdown in growth which led to a fall in income
and thus reduced rates of consumption. The private investment rates have also been fairly flat
since 1990s whereas public investment rates have fallen. Mid-1990s, the economy’s share of
global exports had also seen a decline. This was due to the combinations of other rising Asian
economies as well as an appreciation in the Japanese Yen which led a loss of its export
competitiveness.10
The characteristics experienced through this decade make it difficult to resist that there is a
liquidity trap at play. The characteristics being very low interest rates, Japan’s central banks’
inability to induce aggregate demand by adopting expansionary monetary policy,
additionally, Japan’s consistent below capacity performance.
The liquidity trap theory proposes that such a trap can occur when current productive
capacity is actually more than future productive capacity. This can be explained by way of
Japan’s demographic trends – it is the oldest country in the world and its declining birth rate
along with a lack of immigration indicates why this might be so.11 Such a declining trend also
affects the economy’s future investment – an increase in the proportion of dependents and
retirees decreases output and investment and accordingly, the return on investments.12 Some
other explanations of the trap look into Japan’s capital market inefficiencies and its
institutional peculiarities.
ESCAPING FROM THE LIQUIDITY TRAP
Once an economy is in a liquidity trap situation, it is very difficult to implement traditional
monetary policy tools in order to get out of the same. The solutions to a liquidity trap can be
broadly categorised into: structural reform, fiscal expansion and alternative monetary policy.
Leigh, Daniel. “Monetary Policy and the Lost Decade: Lessons from Japan.” Journal of Money, Credit and
Banking, vol. 42, no. 5, 2010, pp. 833–857. JSTOR, JSTOR, www.jstor.org/stable/40732615.
9
Krugman, Paul R., et al. “It's Baaack: Japan's Slump and the Return of the Liquidity Trap.” Brookings Papers
on Economic Activity, vol. 1998, no. 2, 1998, pp. 137–205. JSTOR, JSTOR, www.jstor.org/stable/2534694.
10
“Japan - OECD Data.” TheOECD, data.oecd.org/japan.htm.
11
“Japan Population 2018.” Japan Population 2018 (Demographics, Maps, Graphs),
worldpopulationreview.com/countries/japan-population/.
12
Basso, Henrique, and Bank of Spain. “How Will an Ageing Population Affect the Economy?” World
Economic Forum, www.weforum.org/agenda/2015/04/how-will-an-ageing-population-affect-the-economy/.
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It is pertinent to note that Japan’s problem is one of demand and not supply, structural reform
may aid in inducing people to increase their consumption. Structural reform of the private
sector may help in increasing investment. Such a reform could also positively influence
future expectations, thus causing higher spending today.
The basic idea of an expansionary fiscal policy is that the government purchases goods and
services and this could lead to an increase in the economy’s aggregate demand and thus
output, even though it will be partially offset by reduction in private consumption. This
policy has however proved to unsuccessful in Japan’s scenario.13
Alternative monetary policy suggests that the economy can break out of this situation through
the help of increased inflationary expectations. Since the real interest rate is difference
between nominal interest rate and expected inflation, even if the nominal interest rate reaches
zero, the central bank can further reduce the rate if they can create private section inflationary
expectation. This can be done by explicitly committing to a higher future price level.
Therefore, this policy is reliant on the central bank’s credibility and that it would indeed
allow inflation rates to increase after which aggregate demand will increase.14
CONCLUSION
According to Krugman and Bernanke the real cause of a liquidity trap is that the real interest
rate remains high. Even if nominal interest rates decline, if inflation does not decline at the
same time, or the economy experiences deflation, then real interest rates may still remain
high or could even rise. This hampers business investment and spending. Hence, the solution
must lie in raising inflation and expected inflation through strict monetary policy. Krugman
and Bernanke emphasize accommodative monetary policy as the principal tool for resolving
a liquidity trap.
Modern mainstream macroeconomics has made courageous attempts to cope and come
to terms with a liquidity trap and has made some advances. However, it is still
entrapped by the limitations of the quantity theory of money, as is evident in the
primary emphasis on monetary expansion to generate inflation in the works of
Krugman, Paul R., et al. “It's Baaack: Japan's Slump and the Return of the Liquidity Trap.” Brookings Papers
on Economic Activity, vol. 1998, no. 2, 1998, pp. 137–205. JSTOR, JSTOR, www.jstor.org/stable/2534694.
13
Svensson, Lars E.O. “Escaping From a Liquidity Trap and Deflation: The Foolproof Way and Others, Journal
of Economic Perspectives, vol. 17, 2003, pp 145-166
14
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Krugman, Bernanke, and the majority of contemporary macroeconomics theorists. In
contrast, Keynes’s analysis in the General Theory still provides a solid basis for
understanding many aspects of a liquidity trap. The Keynesian perspective offers a richer
understanding by applying it when analysing the causes of a liquidity trap and appropriate
policy measures for reviewing growth. Keynesian measures of keeping interest rates low
and mitigating interest rate volatility through monetary policy actions and targeting the
yield curve, in tandem with countercyclical and activist fiscal policies, proactive
employment policies (including direct public-sector employment and state-backed privatesector employment), and efforts to raise the expected marginal efficiency of capital and
labour would be appropriate for countries stuck in a liquidity/investment trap.
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