Is Japan in a liquidity Trap?
From Dickinson College Wiki
Japan’s interest rates have reached a minimum point of virtually zero. Injections of liquidity by the central bank have not been effective in raising the growth rate of broader monetary aggregates.
In 2001 the Bank and Japan began increasing the monetary base. By 2005 the monetary base had increased by 67%, yet the price level and output has no been significantly effected. Quantitative easing has had no effect on the price level or output, which is evidence that money is getting trapped in banks. Source
Another indication that Japan is in a liquidity trap is a decrease in the velocity of money.
Mv=PY
In a normal economy an increase in the Money Supply will increase the price level and/or output. However in a liquidity trap, an increase in the Money supply is offset by a decrease in the velocity of money (v). Money is trapped in banks. This graph shows a steady decrease in the velocity of the yen.
Credit Crunch Theory
Some economist believe that Japan is in a "credit crunch." This theory suggests that the ineffectiveness of monetary policy is caused by problems in the Japanese banking system. There are two parts to this argument.
The first part of the argument focuses on the accumulation of bad bank loans held by Japanese banks which has caused a decline in bank capital. Between 1994 and 1998 the capital asset ratio of the twenty largest Japanese financial institutions fell significantly. A decrease in the capital asset ratio and inability of banks to raise capital in domestic and foreign markets, caused banks to decrease the amount of loans.
Secondly, they say banks now have cautious lending attitude of because of the bankruptcies problems, nonperforming loans, and recession of the 1990s.
These economist argue that even as the Bank of Japan has pumped money into the economy, Japanese banks have withheld loans because of their lack of capital holdings and the cautious lending attitude. The lack of capital holdings and bank’s cautious lending attitudes stem from the Japanese banking mess of the 1990s. source (Japans's Recession: is the Liquidity Trap Back?
Which is correct?
We argue that Japan is in a liquidity trap. In a credit crunch an increase in the monetary base does not effect aggregate output because money is held up by banks which are unwilling to lend money out. Their lack of capital holdings and cautious lending attitudes keep them from making loans. Based on Krugman’s argument, we disagree that the poor condition that banks are in will keep them from lending out money. Banks with a large number of nonperforming loans will want to increase lending and give high risk loans in a last ditch effort to keep from having to declare bankruptcy. They have nothing to loose, so they will take more risks.
Therefore, a credit crunch does not explain why, with a near zero interest rate, an increase in the monetary base is not causing an increase in aggregate output or the price level. On the other hand, a liquidity trap does. In a liquidity trap, the private sectors (people and firms) do not expect high returns on investments, so they are unwilling to make long term investments.
Japan’s close past and present have been marked by a recession. This recession has been cause by the collapse of the economic bubble, large debts that burden enterprises, and a demography (declining fertility rate and decreasing working population). Real interest rates are also high. All of these factors have kept firms from making long term investments and taking the money that the Bank of Japan has pumped into banks.
Japanese Liquidity TrapWhat were the underlying reasons for the problem in Japan?
