The Liquidity Trap: Evidence from Japan
AbstractJapanese economic activity has been stagnant since the collapse of the speculative asset-price bubble in 1990, despite highly expansionary monetary policy which has brought interest rates down to record low levels. 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." According to Keynes, the monetary authority would be unable to reduce interest rates below a non-zero positive interest rate floor if market participants believed that interest rates had reached bottom. Any subsequent monetary expansion, then, would lead investors to increase their holdings of idle cash balances and to become net sellers of government bonds. This paper provides evidence on whether the Japanese economy entered a "liquidity trap" in the recent period, based on a money-demand framework. A Markov regime-switching approach is also used to determine whether the more recent response of money demand to interest rates can be characterized as a separate regime. In general, we do not find any support for the liquidity trap hypothesis. Moreover, we cannot conclude that the response of the demand for money to changes in interest rates was significantly different than in the past. However, we do find that through history the magnitude of the response of money demand to changes in interest rates has been relatively smaller in Japan, suggesting that traditional money demand relationships may not hold.
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Bibliographic InfoPaper provided by Bank of Canada in its series Working Papers with number 97-4.
Length: 28 pages
Date of creation: 1997
Date of revision:
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International topics; Recent economic and financial developments;
Find related papers by JEL classification:
- E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
- E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
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