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

Krugman argues that Japan’s stagnation in the 1990s, with short-term interest rates pinned near zero and conventional monetary expansion seemingly powerless, is a genuine instance of the classical “liquidity trap,” and that properly understood, a liquidity trap is fundamentally a credibility problem rather than evidence that monetary policy is inherently impotent. Using small, explicit intertemporal models with rational expectations, he shows that a monetary expansion the public expects to be sustained will always raise prices (and, with sticky prices, output), so that if expansion fails to work, it must be because the public does not believe the increase in the money supply is permanent; “monetary policy will in fact be effective if the central bank can credibly promise to be irresponsible, to seek a higher future price level.” He further argues that neither international capital mobility nor financial intermediation offers an automatic escape: goods markets are not perfectly integrated even when capital is mobile, so required real interest rates can still be negative, and a liquidity trap can coexist with perfectly healthy banks since the central bank cannot move broad monetary aggregates once money and short bonds become perfect substitutes. On the Japan-specific empirics, he estimates the 1998 output gap at 8 percent or more, judges the banking system’s bad loans to be less central to the slump than conventional wisdom supposed, and offers the deliberately provocative suggestion that the Bank of Japan target roughly 4 percent inflation for fifteen years – a number he says “should not really be taken seriously,” intended mainly to provoke research into the structural reasons (chiefly demographics) why Japan’s full-employment real interest rate might need to be negative for a long time.

Target Zones and Exchange Rate Dynamics

Krugman presents a highly simplified continuous-time model of how an exchange rate behaves inside a credible target zone – a band the authorities are committed to defend at its edges, but need not actively defend away from the edges. Against the “naive view” that the rate should simply float freely until it hits the edge of the band and then act as if fixed, Krugman shows that forward-looking speculators’ expectation of future defense stabilizes the rate throughout the band, even while no intervention is actually taking place: the resulting fundamentals-exchange-rate relationship is an S-shaped curve that is everywhere flatter than the 45-degree line a freely floating rate would trace out. The extent of this stabilization is shown to depend, in a simple closed-form way, on three things: the sensitivity of the current exchange rate to its own expected rate of change, the volatility of the process driving the exchange rate’s underlying “fundamentals,” and the credibility of the authorities’ commitment to defend the zone – and the paper also extends the result to a zone that is only imperfectly credible, showing that lower credibility makes the fundamentals-exchange-rate relationship steeper and less stabilizing, converging to the free-float case as credibility goes to zero. The model, while deliberately stripped of richer dynamics (anticipated future shocks, sticky prices, slow-moving wealth), gives a clean analytical account of why target-zone exchange rates should be less volatile than free-floating rates even without observed central-bank intervention.

Paul R. Krugman | Macro Paper Warehouse

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

Target Zones and Exchange Rate Dynamics