JAPAN'S TRAP Paul Krugman May 1998 Japan's economic malaise is first and foremost a problem for Japan

itself. But it also poses problems for others: for troubled Asian economies desperately in need of a locomotive, for Western advocates of free trade whose job is made more difficult by Japanese trade surpluses. Last and surely least - but not negligibly - Japan poses a problem for economists, because this sort of thing isn't supposed to happen. Like most macroeconomists who sometimes step outside the ivory tower, I believe that actual business cycles aren't always real business cycles, that some (most) recessions happen because of a shortfall in aggregate demand. I and most others have tended to assume that such shortfalls can be cured simply by printing more money. Yet Japan now has near-zero short-term interest rates, and the Bank of Japan has lately been expanding its balance sheet at the rate of about 50% per annum - and the economy is still slumping. What's going on? There have, of course, been many attempts to explain how Japan has found itself in this depressed and depressing situation, and the government of Japan has been given a lot of free advice on what to do about it. (A useful summary of the discussion may be found in a set of notes by Nouriel Roubini . An essay by John Makin seems to be heading for the same conclusion as this paper, but sheers off at the last minute). The great majority of these explanations and recommendations, however, are based on loose analysis at best, purely implicit theorizing at worst. Japan is depressed, we are told, because of too much corporate debt, or the refusal of banks to face up to their losses, or the overregulation of the service sector, or the aging of its population; recovery requires tax cuts, or a massive bank reform, or maybe cannot be achieved at all until the economy has painfully purged itself of excess capacity. Some or all of these propositions may be true; but it is hard to know unless we have some clear framework for understanding the current predicament. 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

Structural reforms that raise the long-run growth rate (or relax non-price credit constraints) might alleviate the problem. too close to assuming its conclusions to give us the kind of guidance we want. even aside from the dependence of IS-LM analysis on the ad hoc assumption of price inflexibility. the conditions under which that trap emerges correspond. 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. convince the private sector that it will not reverse its current monetary expansion when prices begin to rise! . But the simplest way out of the slump is to give the economy the inflationary expectations it needs. to some features of the real Japanese economy. so might deficitfinanced government spending. 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. the policy implications are radical.the short-term real interest rate that would be needed to match saving and investment may well be negative. because of unfavorable demographic trends . and curiosa like the liquidity trap have been all but forgotten. As a result. the country therefore "needs" expected inflation. To preview the conclusions briefly: in a country with poor long-run growth prospects .intellectual company. incidentally. Hicks noted right at the beginning). IS-LM has been hidden away in the back pages of macroeconomic textbooks.that is. If prices were perfectly flexible. Indeed. If this stylized analysis bears any resemblance to the real problem facing Japan. regardless of monetary policy if necessary by deflating now so that prices can rise in the future. But here we are with what surely looks a lot like a liquidity trap in the world's secondlargest economy. the economy cannot get the expected inflation it needs. The purpose of this paper is to show that the liquidity trap is a real issue .for example. and the public expects price stability in the long run. But if current prices are not downwardly flexible. Moreover. is ineffective. 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 . After all. given as little space as possible. the economy would get the inflation it needs. no matter how large. and in that situation the economy finds itself in a slump against which short-run monetary expansion. since nominal interest rates cannot be negative. many economists probably have doubts about whether anything like a liquidity trap is actually possible in a model with better microfoundations.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. in at least a rough way.

The fifth section argues that despite the highly stylized nature of the analysis. interest. output is simply given (i.does not alter the basic conclusions: neither investment nor even the possibility of exporting excess savings to other countries necessarily eliminate the possibility of a liquidity trap. the money supply. The third part introduces short-run price inflexibility. Output.an assumption I will relax later). And this maximum rate of deflation can be negative .is completely ineffectual at increasing output. rather than to be realistic. even when prices are perfectly flexible there is a maximum rate of deflation that cannot be exceeded no matter what the central bank does. and shows that when an economy "needs" inflation. especially the apparent implication that Japan may need to adopt more inflationary policies than any responsible person is now willing to propose. . Individuals are assumed to maximize their expected utility over an infinite horizon. it does shed considerable light on Japan's quandary. interest.e. the interest rate. So I will concentrate on the simplest possible fully-consistent model that establishes relationships among the four main macroeconomic aggregates: output. 1.that is. and the price level. It is in this sense that an economy can indeed suffer from a liquidity trap. In this model individuals are identical and live forever. and with flexible prices will get it regardless of monetary policy.. The next section shows that while under normal circumstances prices in this model are proportional to the money supply. Finally.This paper is in six parts. the last part considers policy implications. and prices. It begins by describing an extremely stylized fullemployment model of money. under certain well-defined circumstances the economy needs inflation. money. temporary monetary expansion . and the demand for money arises purely from a "cash-in-advance" assumption: people are required to pay cash for goods. The fourth part then argues that making the analysis a bit less stylized . so that there are no realistic complications involving distribution within or between generations. a simplified version of Lucas (1982).introducing investment and international trade .defined as expansion that does not raise the long-run price level . and prices The purpose of this paper is to demonstrate possibilities and clarify thinking. it is an endowment economy .

while the particular form of the utility function is not important. and must obey its own intertemporal budget constraint. so that individuals maximize U = ln(c1) + D ln(c2) + D2 ln(c3) + . In each period individuals receive an endowment yt. individuals cannot simply consume their own endowment: they must buy their consumption from someone else. for convenience I make it logarithmic.positive or negative (a lump-sum tax) from the government. if we make some simplifying assumptions the model's implications can be derived with almost no algebra. After the capital market is held. However. Their consumption during the period is then constrained by the cash with which they emerge from this trading: the nominal value of consumption. and that the government will also hold the money supply constant at a level M*. with a nominal interest rate it. Analyzing this model in general requires a careful specification of the budget constraints of both individuals and the government. and of intertemporal choices. Let us assume that from the second period onwards output (and therefore also consumption) will remain constant at a level y*.. The government also makes transfers or collects taxes (no government consumption at this point). money is created or destroyed by the government via open market operations each period . Then we can immediately guess at the solution from period 2 on: the price level will remain constant at P* = M*/y*. Pt ct . The purchase of goods requires cash. It is straightforward to confirm that this is indeed an equilibrium: one plus the real interest rate equals the ratio of marginal utility in any two successive periods. cannot exceed money holdings Mt. At the beginning of each period there is a capital market. each individual purchases his desired consumption. because the nominal interest rate is positive individuals have an incentive to acquire only as much cash as they need.. where ct is consumption in period t. and the interest rate will also be constant at a rate i* = (1D)/D. and D<1 is a discount factor. while receiving cash from the sale of his own endowment. the government enters into the capital market and buys or sells bonds. at which individuals can trade cash for one-period bonds. so all money will indeed be spent on consumption. While I will think of this as a one-good economy. There may also be a transfer . which takes into account any seignorage that may result from increases in the money supply over time. Finally. .that is.

. leading to a higher price level and a lower nominal (but not real) interest rate.All the action. since consumption must equal output in each period. The second relationship comes from intertemporal choice. By holding one less yen in period 1. At an optimum this change must leave him indifferent. So the cash-in-advance constraint will be binding: Pc =Py = M. But the marginal utility of consumption in period 1. simultaneously determining the interest rate and the price level. It follows that we must have c/c* = D-1 (P*/P)/ (1+i) or 1+i = D-1 (c*/c) (P*/P) or. D-1 (y*/y)-1 . then. which the economy will deliver whatever the behavior of nominal prices. Let us use un-subscripted letters to represent first-period output. . consumption. as drawn. 1+i = D-1 (y*/y) (P*/P) This says that the higher is the current price level. the marginal utility in 2 is D/c*. The two relationships are shown in Figure 1 as MM and CC respectively. the lower the nominal interest rate. It is also immediately apparent that an increase in the first-period money supply will shift MM to the right. when the nominal interest rate is positive . an individual gives up 1/P units of first-period consumption but allows himself to consume (1+i)/P* additional units in period 2. Under normal circumstances that is. The easiest way to think about this is to say that there is an equilibrium real interest rate.individuals will hold no more cash than they need to make their consumption purchases. finally. hence higher P means lower i. they intersect at point 1. any rise in the current level creates expected deflation. etc. so that P = M/y So under normal circumstances there is a simple proportional relationship between the money supply and the price level. goes into determining the price level and interest rate in the first period. is 1/c. given the assumed utility function. since the future price level P* is assumed held fixed. Meanwhile. Our first relationship comes from the monetary side. interest rate.

and then imagine an initial open-market operation that increases the firstperiod money supply.or equivalently that the central bank will do whatever is necessary to keep the post-2 price level stable). such as consols. Because spending is no longer constrained by money. however. Since the nominal interest rate cannot become negative. or for that matter the United States during the 1930s: long rates in Japan are positive. to which we now turn.While this is surely the normal case.so that the intersection of MM andCC is at a point like 3. because then money would dominate bonds as an asset. there is also another possibility. this operation will increase the price level and reduce the interest rate. however. It is probably worth emphasizing here that the interest rate at point 2 is zero only on one-period bonds. What must therefore happen is that any increase in the money supply beyond the level that would push the interest rate to zero is simply substituted for zero-interest bonds in individual portfolios (with the bonds being purchased by the central bank in its open-market operation!). but short-term rates are indeed very close to zero. and therefore also the long-run price level at P*. it is lowering the expected rate of money growth M*/M. A good way to think about what happens when money becomes irrelevant here is to bear in mind that we are holding the long-run money supply fixed at M*.the expected rate of inflation P*/P. Now what we know is that in this full employment model the economy will have the same real interest rate whatever the central bank does. And such a monetary expansion can clearly drive the economy down the CC curve as far as point 2 in Figure 1. and also . it would not be zero on longer-term bonds. 2. (Throughout we imagine that the money supply from period 2 onwards remains unchanged . with no further effect on either the price level or the interest rate. as we have already seen. When money becomes irrelevant Suppose that you start with an economy in the equilibrium described by point 1 in Figure 1. This is important if one is trying to map the model onto the current situation in Japan. the MM curve becomes irrelevant. with a negative nominal interest rate? The answer is clearly that the interest rate cannot go negative. Initially. So when the central bank increases the current money supply.if it does succeed in raising the price level . But what happens if the money supply is increased still further . no matter how large the money supply may be. . the economy has a minimum rate of inflation or maximum rate of deflation. the economy stays at point 2.

Now suppose that the central bank in effect tries to impose a rate of deflation that exceeds this minimum . What happens is that the economy deflates now in order to provide inflation later.and that these conditions are fulfilled in Japan. This conclusion may surprise those few readers who recall the tortured historical debate about the liquidity trap. and any excess money will have no effect: the rate of deflation will be the maximum consistent with a zero nominal rate. the required real interest rate is negative if y/y* > 1/D This condition may seem peculiar. I will argue later that there are some realworld conditions under which the idea of declining endowment does not seem all that unreasonable . the public then expects the price level to rise. In this model the problem does not arise . and no more. That is. but the real rate needs to be negative. then the economy "needs" inflation.but the reason is a bit peculiar. And to repeat.which it does by making the current money supply M large relative to the future supply M*. At this point we have something that is sort of like a liquidity trap: money becomes irrelevant at the margin. and this provides the necessary negative real interest rate. or even positive! Suppose that the required real rate of interest is negative. much of which focussed on the question of whether wage and price flexibility were effective as a way of restoring full employment. this fall in the price occurs regardless of the current money supply.which may have a thing about price stability. P falls below P*. we normally think of economies as growing rather than shrinking! However. Specifically. but finds itself presiding over inflation no matter what it . Of course. which will be the case if the economy's future output is expected to be sufficiently less than its current output. Now this may seem a silly thought experiment. Market-clearing will require a negative real interest rate if the marginal utility of consumption in period 2 is greater than that of consumption in period 1. because any excess money will simply be hoarded without adding to spending. The condition under which the required real interest rate is negative is straightforward in this simple endowment economy. What will happen is that the economy will simply cease to be cash-constrained. But aside from frustrating the central bank . in a flexible-price economy even the necessity of a negative real interest rate does not cause unemployment. After all. Why would a central bank try to impose massive deflation? But the maximum rate of deflation need not be large. if the current money supply is so large compared with the future supply that the nominal rate is zero. and excess cash holdings. and an attempt by the central bank to achieve price stability will lead to a zero nominal interest rate. given the assumed utility function.

which is decreasing in the interest rate. no matter how large. with no effect on spending. as just indicated. 3. I will simply assume that the price level in period 1 is predetermined . can get the economy to full employment. Given the utility function.that people expect deflation. yf is high compared with the future . we can immediately write an expression for current real consumption. The curve IS. the economy is in a classic liquidity trap.this trap has no adverse real consequences. the cash-in-advance constraint will be binding. shows how output will be determined by consumption demand. is that even if prices are expected to be stable. we need to introduce some kind of nominal rigidity. In particular. so that even a zero nominal rate is a high real rate. In this sticky-price world the level of period-1 consumption and output must still be equal. And therefore no openmarket operation. Under what conditions will a liquidity trap occur? One possibility is that P is high compared with P* .or to put it differently. peoples' expected future real income is low compared with the amount of consumption needed to use . also.so that the economy now acquires a Keynesian feel.does . that this productive capacity need not be fully employed. And suppose. The liquidity trap Suppose. up to point 2. up to a point . as long as the nominal interest rate is positive. The other possibility. now. But what if productive capacity is at a point like 3? Then the same argument as in the previous section applies: since the nominal interest rate cannot go negative. with a maximum productive capacity yf in period 1. In short. which becomes the "IS curve" determining real output: c = y = D-1 y* (P*/P) (1+i)-1 Figure 2 illustrates the joint determination of the interest rate and output in this case. in both senses. any increase in money beyond the level that drives the rate to zero will simply be substituted for bonds. that the consumption good is produced rather than simply appearing. To turn this analysis into a real problem. and monetary policy can affect output.specifically. however. and the assumption that consumption will bey* in period 2. Meanwhile. (In period 2 and subsequently output will still be assumed to take on the valuey*). so we will have the MM curve y = M/P Increasing the money supply can now increase output. but now output adjusts to consumption rather than the other way around.

then even with a zero interest rate they may want to save more than the economy can absorb. So we have now seen that a fully specified model. it is fairly straightforward to see that if we have a "Tobin's q" model of investment. of course. 4. After all. suppose that for whatever reason consumers right now want to save a large fraction of their income.one in which there is no investment. which does not fudge either the role of money or the necessity of making intertemporal choices. And in that case. a positive marginal product of capital is no guarantee that individuals face a positive real rate of return.he must also take into account the prospective real capital loss as q declines from its current high level to a more normal level. the economy cannot absorb any savings . one that is closer to the language of applied macroeconomics: if people have low expectations about their future incomes. However. Investment at home and abroad A liquidity trap can happen in a very simple economy . and therefore no way for consumers in the aggregate to make tradeoffs between present and future.but I will come to that point below). In order to persuade firms to invest that much. can indeed generate a liquidity trap.today's capacity. no matter what the central bank does with the current money supply. in which periods of high investment are associated with a high real price of assets. (In this case. In that case. But in the future. Does this eliminate the liquidity trap as an interesting possibility? To build a fully specified model with investment would require a longer and more elaborate paper. q must be high.either by investing at home or acquiring assets abroad? At first sight it might seem that allowing for investment and/or foreign trade should make nonsense of the idea that an economy needs a negative real interest rate to generate adequate demand. and with downwardly inflexible prices that may not be possible. As a . using the proceeds to buy foreign assets with a positive real return. Now while an investor who buys capital now will collect any rents on the capital . But can it still happen once we allow some way to use current production to buy future consumption . to persuade people to spend enough now may require a negative real interest rate. when consumers want to save less. it cannot reflate the economy sufficiently to restore full employment. Or to put it yet another way. even with diminishing returns the marginal product of capital is surely always positive. To see why. and one can always run a trade surplus. q will be lower.which will be positive as long as the marginal product of capital is positive .

say. the real return in terms of domestic consumption could well be negative. because the prospect of eventual appreciation would support the currency now. export of capital will normally be associated with a depreciation in the real exchange rate. given the economy's lack of real growth since 1991. So if a country needs to export a lot of capital now. A basically similar argument applies to attempts to export savings. So allowing for investment at home and abroad. True. by investing abroad.37 percent. selling them low. Suppose that we postulate that even at a zero real interest rate Japanese consumers insist on saving a great deal right now. Is Japan in a liquidity trap? Up to this point. Japan certainly more or less meets the interest-rate criterion: at the time of writing the overnight money-market rate was 0.result. and hence that the real interest rate be negative. Both of these points may be somewhat clearer if we try to think roughly of what they might mean in Japan's case. to get the level of investment needed to absorb temporarily very high savings might require that investors be prepared to accept a negative real rate of return. Similarly. how did it get there? An economy is in a liquidity trap if aggregate demand consistently falls short of productive capacity despite essentially zero short-term nominal interest rates. Yet even a zero real interest rate (compared with positive rates abroad) might not generate sufficient depreciation. a very high P/E ratio on Japanese stocks. although originally arising in the context of a pseudo-static model. can be given a dynamically consistent interpretation. But just because something is possible does not mean that it is relevant. The economy also certainly seems to be operating well below capacity. that is. to generate a trade surplus large enough to export all the savings would require a very weak real yen. does not make it impossible. the OECD and IMF estimates of output gap are surprisingly modest. while it may make a liquidity trap somewhat less plausible. . But even a zero real interest rate might not be enough to get that P/E ratio. a decline in the domestic price level compared with the foreign even when measured in a common currency. to be repatriated later. Even though the real return in terms of foreign goods is certainly positive. 5. because stock prices would be limited by the expectation of an eventual fall. I have tried to demonstrate that the idea of a liquidity trap. Do we really think that Japan is in a liquidity trap .and if it is. If there are nontraded goods. To induce domestic firms to invest all those savings now would require a very high price of capital in place . but will probably save much less at some future date. it will from its own point of view be buying foreign assets high.

such as the troubles of the banking system. In a perfect capital market those who expect their income to rise would tend to engage in dissaving. we can ask why one might expect Japan's future capacity to be relatively low compared with today's. If one uses even a conservative estimate of Japanese potential growth since 1990 . Suppose that at any given time some people expect their future income to be higher than their current income. and the equilibrium real interest rate will be lower than it would have been in a more efficient capital market. may also lead to some credit rationing that deters investment. But suppose that this is difficult that consumption loans are hard to come by. so it is substantially easier to make the case that per capita productive capacity might actually be lower at some future date than it is today. because of shifting composition. they may be unable to invest as much as they otherwise would. however. In the absence of productivity growth. But it is also true that at least some Japanese institutional pecularities the relatively small use of credit cards. say. the prospects for a liquidity trap also depend on investment demand. potential output. the high downpayments required on expensive houses (see Ito 1992) may contribute to the problem. And the obvious answer is demography: Japan's combination of declining birth rate and lack of immigration apparently means a shrinking rather than growing labor force over the next several decades.y* in the model . others expect it to be lower. Moving outside the formal model. those numbers are based not on economic analysis but on a smoothing procedure that automatically builds any sustained slump into the estimated trend in potential output (using the same procedure on the United States in the 1930s finds the economy at full capacity by 1935). And institutional problems. Then those who expect their income to rise will not contribute as much to the demand for funds as those who expect it to fall contribute to the supply.the economy now appears to be in a very deep slump indeed. a liquidity trap will arise only if future productive capacity is actually lower than current capacity.However. Moreover. the labor force will drop faster than the population. The case that a negative real interest rate is necessary can be strengthened if we allow for heterogeneity among individuals plus imperfect capital markets. 15 or 20 years out . Notice that we need not argue that Japanese capital markets are especially inefficient: this can be viewed simply as a reason why aggregate capacity need not actually be falling to require a negative real interest rate. And to the extent that firms are financially constrained by the debt run up in the past. . why? In the model of sections 1-3. Here demography again comes into play: the prospective decline in the labor force reduces the expected return on investments. If Japan is in a liquidity trap.say. 2 percent . Before loosening that constraint.could actually be below current capacity.

however.On the whole. do the economy no good if it is stuck at point 2 in any case. and see no reason to believe that even radical reform would be enough to jolt the economy out of its current trap. Deregulation might create new investment opportunities. other "structural" reasons that are widely cited. I at least am far from sure that the kinds of structural reform being urged on Japan will increase demand at all. indeed. encouraging higher spending now. 6. And it gives every appearance of being in a liquidity trap . reform its corporate accounting. But while such measures will increase the economy's microeconomic efficiency. the immediate problem facing Japan is one of demand. What is to be done? Japan is an economy that is almost certainly producing well below its productive capacity . is that when one poses the question "How will this increase demand?" . Let us consider each in turn.that is. while it is quite easy to make the case that Japan really is in a liquidity trap. Structural reform: Everyone agrees that Japan needs structural reform: it needs to clean up its banks. To be helpful in the current situation. yet the economy remains depressed. and unconventional monetary policy. . This lack of a clear link between the structural issues and the proximate problem has some important policy implications. not supply.that is.the answers are actually quite vague. as opposed to simply causing garden-variety microeconomic inefficiency. conventional monetary policy appears to have been pushed to its limits. It is possible to imagine several ways in which this might happen. which push point 3 to the right. as we will soon see. do not necessarily explain why demand should be inadequate. Demography seems to be the leading candidate.as opposed to supply . A reformed financial sector might be able to lend to people and firms that are now credit-constrained. fiscal expansion. raising investment demand. that is. deregulate its service sector. if unemployment rises as a result of increased efficiency the country might actually be worse off. And conceivably reform might raise expectations of future income. while they do amount to an impressive litany of sins. it is much harder to give a convincing explanation of why. will they help it recover? Bear in mind the trap shown in Figure 2: policy moves that increase yf. Measures that raise Japan's supply capacity but leave demand where it is will not help the situation. structural reform must somehow induce people to spend more. What can be done? There seem to be three main answers: structural reform. and so on. The striking thing about discussion of structural reform.

is it really true that it is impossible to use the economy's resources to produce things people actually want? Monetary policy: It may seem strange to return to monetary policy as an option. rudimentary as it is. and that in such cases fiscal pump-priming is the only answer. airports few people use. so that tax cuts would have no effect. And that is why monetary policy is ineffective! Japan has been . but it does suggest that fiscal expansion could work. Obviously the model is subject to Ricardian equivalence. A permanent as opposed to temporary monetary expansion would. even if Japan has probably been too ready to use it as an excuse. it seems to indicate that a liquidity trap is something that can last indefinitely. could indeed increase demand and output. But the framework here. it cannot make any distinction between temporary and permanent policy changes. since the economy is demandrather than supply-constrained even wasteful spending is better than none. money is still neutral ..because it would cause expectations of inflation. in other words. haven't we just seen that it is ineffective? But it is important to realize that the monetary thought experiments we have performed have a special characteristic: they all involve only temporary changes in the money supply. Much of this spending has been notoriously unproductive: bridges more or less to nowhere. however. Of course the Bank of Japan does not announce whether its changes in the monetary base are permanent or temporary. etc. Because the traditional IS-LM framework is a static one. because they believe that the central bank is committed to price stability as a long-run goal. while they would be partly offset by a reduction in private consumption expenditures. After all. In the flexible-price version of the model. The framework here is rather different in its implications for monetary policy.that is. Let us now bring this discussion back to earth. This point needs enlarging upon. And partly as a result. But there is a government fiscal constraint.Fiscal policy: The classic Keynesian view of the liquidity trap is. and to Japan in particular. of course. even when money and bonds turn out to be perfect substitutes in period 1. is it the right one for Japan? Japan has already engaged in extensive public works spending in an unsuccessful attempt to stimulate its economy. But government purchases of goods and services in the first period. and hence reduce the real interest rate. be effective . an equiproportional increase in the money supply in all periods will still raise prices in the same proportion. suggests a quite different view. While this policy could work. the monetary expansion would raise the expected future price level P*. True. But we may argue that private actors view its actions as temporary. So what would a permanent increase in the money supply do in the case where prices are predetermined in period 1? Even if the economy is in a liquidity trap in the sense that the nominal interest rate is stuck at zero. that it demonstrates that under some circumstances monetary policy is impotent. And anyway.

is for the central bank to credibly promise to be irresponsible . (1982). or it could be 20). . In the quasi-static IS-LM version of the liquidity trap. Of course. Lucas. and the only way to do that is to create expectations of inflation. Takatoshi (1992). then. price adjustment or spontaneous structural change will eventually solve the problem. Journal of Monetary Economics 22. "Interest rates and asset prices in a two-currency world". that the basic premise that even a zero nominal interest rate is not enough to produce sufficient aggregate demand . In the long run Japan will work its way out of the trap. however.unable to get its economy moving precisely because the market regards the central bank as being responsible. and expects it to rein in the money supply if the price level starts to rise. whatever the policy response. The Japanese Economy. Ito. it is not necessary that Japan do anything. thereby producing the negative real interest rates the economy needs. This sounds funny as well as perverse. But on the other hand.is not hypothetical: it is a simple fact about Japan right now. Econometrica. Bear in mind. A dynamic analysis makes it clear that it is a temporary phenomenon . Cambridge: MIT Press. (1937). R.R. it appears as if the slump could go on forever. 3-42. J. Even without any policy action.. "Mr.. in the long run .in the model it only lasts one period. REFERENCES Hicks.to make a persuasive case that it will permit inflation to occur. Unless one can make a convincing case that structural reform or fiscal expansion will provide the necessary demand. Keynes and the classics". the only way to expand the economy is to reduce the real interest rate. The way to make monetary policy effective. although the length of a "period" is unclear (it could be three years.