It's Baaack: Japan's Slump and the Return of the Liquidity Trap

The liquidity trap - that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant because money and bonds are essentially perfect substitutes - played a central role in the early years of macroeconomics as a discipline. Since then, the liquidity trap has steadily receded both as a memory and as a subject of economic research. Because of Japan's current situation, it is time to reexamine the theory of liquidity traps, which has turned out not to be irrelevant after all. An extended generic discussion of the causes and consequences of liquidity traps is presented. The central new conclusion of this analysis is that a liquidity trap fundamentally involves a credibility problem: markets believe that the central bank will target price stability, given the chance, and that any current monetary expansion is merely transitory. Some specific questions concerning Japan are addressed. It is argued that Japanese banks have played less of a causal role in the country's macroeconomic malaise than is widely assumed.