A liquidity trap is when lowering interest rates fails to stimulate the economy. Japan is in one. To a hardcore (post-)Keynesian, the reason is fear - no one with money wants to part with it, regardless how low the return on cash-equivalents is. Paul Krugman has a piece on his website <http://web.mit.edu/krugman/www/japtrap.html> (Japtrap, cute, eh?) that applies the analysis to Japan, an recommends inflation as the cure (four grafs from it follow). Krugman's talk of the natural interest rate and balancing saving & investment would make a post-Keynesian scream, but what the hell?
Doug
----
Krugman:
>Economists of a certain age - basically my age and up - do have a
>theoretical framework of sorts for analyzing the situation: Japan is in
>the dreaded "liquidity trap", in which monetary policy becomes
>ineffective because you can't push interest rates below zero. The
>celebrated paper by Hicks (1937) that introduced the IS-LM model also
>showed, in the context of that model, how monetary policy might become
>ineffective under depression conditions. And for a long time
>macroeconomists kept the liquidity trap in mind as an important
>theoretical possibility, if not something one was likely to encounter in
>practice. But the IS-LM model, while it continues to be the workhorse of
>practical policy analysis in macroeconomics, has increasingly been
>treated by the profession as a sort of embarrassing relative, not fit to
>be seen in polite intellectual company. After all, even aside from the
>dependence of IS-LM analysis on the ad hoc assumption of price
>inflexibility, that analysis is at best a very rough attempt to squeeze
>fundamentally intertemporal issues like saving and investment into a
>static framework (a point which, incidentally, Hicks noted right at the
>beginning). As a result, IS-LM has been hidden away in the back pages of
>macroeconomic textbooks, given as little space as possible; and curiosa
>like the liquidity trap have been all but forgotten.
>But here we are with
>what surely looks a lot like a liquidity trap in the world's
>second-largest economy. How could that have happened? What does it say
>about policy? For in a way the criticisms of IS-LM are right: it is too
>ad hoc, too close to assuming its conclusions to give us the kind of
>guidance we want. Indeed, many economists probably have doubts about
>whether anything like a liquidity trap is actually possible in a model
>with better microfoundations.
>The purpose of this paper is to show that
>the liquidity trap is a real issue - that in a model that dots its
>microeconomic i's and crosses its intertemporal t's something that is
>very much like the Hicksian liquidity trap can indeed arise. Moreover,
>the conditions under which that trap emerges correspond, in at least a
>rough way, to some features of the real Japanese economy. To preview the
>conclusions briefly: in a country with poor long-run growth prospects -
>for example, because of unfavorable demographic trends - the short-term
>real interest rate that would be needed to match saving and investment
>may well be negative; since nominal interest rates cannot be negative,
>the country therefore "needs" expected inflation. If prices were
>perfectly flexible, the economy would get the inflation it needs,
>regardless of monetary policy - if necessary by deflating now so that
>prices can rise in the future. But if current prices are not downwardly
>flexible, and the public expects price stability in the long run, the
>economy cannot get the expected inflation it needs; and in that
>situation the economy finds itself in a slump against which short-run
>monetary expansion, no matter how large, is ineffective.
>If this stylized
>analysis bears any resemblance to the real problem facing Japan, the
>policy implications are radical. Structural reforms that raise the
>long-run growth rate (or relax non-price credit constraints) might
>alleviate the problem; so might deficit-financed government spending.
>But the simplest way out of the slump is to give the economy the
>inflationary expectations it needs. This means that the central bank
>must make a credible commitment to engage in what would in other
>contexts be regarded as irresponsible monetary policy - that is,
>convince the private sector that it will not reverse its current
>monetary expansion when prices begin to rise!