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The Foreign Exchange Origins of Japan's Economic Slump and Low Interest Liquidity Trap

  • Ronald McKinnon

    (Stanford University, California)

  • Kenichi Ohno

    (National Graduate Institute for Policy Studies, Tokyo)

Japan's macroeconomic problem has yet to be properly diagnosed. Throughout the 1990s, policy makers could not decide on the proper macro economic measures to combat the country's severe economic slump. We propose a unified explanation, with deep historical roots, of why aggregate private demand failed to recover after Japan's stock and real estate bubbles burst in 1991 and deflationary pressure continues. The problem is not purely "made in Japan". It arises from Japan's unbalanced mercantile relationship with the United States. Starting in the early 1970s, numerous trade disputes between the two countries created tensions that were (temporarily) resolved by the yen going ever higher against the dollar up to 1995. In the last two decades, this persistent pressure for the yen to rise was further aggravated by Japan's large current-account (saving) surpluses as the counterpart of America's large current account (saving) deficits. The legacy is the expectation that trade and financial tensions will recur so that the yen will be higher 10, 20, or 30 years from now - with Japan's (wholesale) price level forced correspondingly lower and nominal interest rates on yen assets remaining more than four percentage points less than those on dollar assets. This fear of yen appreciation, whose timing is erratic and unpredictable, now inhibits private domestic investment by both Japanese firms and households. Our theory also explains why, in the late 1990s, nominal interest rates on short-term yen assets were compressed toward zero so as to destroy the normal profit margins of the banking system. In this liquidity trap, the Bank of Japan-whose monetary policy has been quite "expansionary" - is powerless to stimulate the flagging economy. To spring the liquidity trap, eliminate deflationary pressure, and restore macro economic balance in Japan, the American and Japanese governments must act jointly to quash the expectation that the yen will be higher in the future than it is today.

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Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 052000.

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Length: 37 pages
Date of creation: Aug 2000
Date of revision:
Handle: RePEc:hkm:wpaper:052000
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  1. Adam S. Posen, 1998. "Restoring Japan's Economic Growth," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 35, December.
  2. Simon Wren-Lewis & Rebecca Driver, 1998. "Real Exchange Rates for the Year 2000," Peterson Institute Press: Policy Analyses in International Economics, Peterson Institute for International Economics, number pa54, 03.
  3. Thomas F. Cargill & Michael M. Hutchison & Takatoshi Ito, 1997. "The Political Economy of Japanese Monetary Policy," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262032473, August.
  4. Kathryn Dominguez & Jeffrey A. Frankel, 1990. "Does Foreign Exchange Intervention Work?," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 16, December.
  5. Ronald I. McKinnon, 1996. "The Rules of the Game: International Money and Exchange Rates," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262133180, August.
  6. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
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