Is Shutting Krugman's Liquidity Trap the Answer to Japan's Problems?

Paul Krugman has argued that the primary source of Japan’s current problems is that the economy faces a liquidity trap. According to Krugman, this has occurred because Japan confronts negative equilibrium real interest rates for a substantial period. To escape the trap, the Bank of Japan must generate inflationary expectations. This paper extends Krugman’s argument to consider the impact of demographic change on savings and investment and finds that Japan’s equilibrium real interest rate is unlikely to be negative for any considerable period. It argues instead that real forces, particularly productivity shocks and the problems of reallocating resources in their wake, are important contributors to Japan’s predicament. Consequently, simply generating inflation may not deliver sustained improvements in the macroeconomic situation. Successful reform, particularly to the banking sector, may be more important to a sustained recovery.