Japan, world‟s third largest economy (in terms of nominal GDP) went into a great depression after the asset price bubble collapse in the Japanese economy during 1991 and has still not completely recovered from the same.
It showed strong economic growth during the prosperous 1980s but the situation worsened as it reached the 1990s, as the interest rates offered by banks in Japan became very low. Due to high personal savings rates during the 1980‟s, Japanese firms started relying heavily on traditional bank loans rather than issuing stock or bonds via the capital markets to acquire funds. The close relationship of corporations to banks and the implicit guarantee to a taxpayer bailout of bank deposits reduced the lending standards. The banks lent more regardless of the quality of the borrower and thus inflated the asset bubble economy. Due to the availability of cheap and easily available credit, people stated borrowing hugely and invested heavily in domestic as well as foreign stock markets. To curb inflation the Bank of Japan increased the interest rates sharply resulting in credit crisis and crash of equity market. Debt crisis followed and the Japanese banks and insurances were loaded with huge debts. The financial institutions were bailed out through capital infusions from the govt. and loans from the central bank but that didn‟t rectify the situation. Instead the banks kept on offering funds to the debt ridden firms which could barely sustain on them and as a result worsened the economic growth of Japan. Firms started to employ temporary workers thus increasing the unemployment rate and the nominal wages decreased. GDP growth was slow and unable to absorb the resulting increase in unemployment. In response, the Japanese government raised VAT rates from 3% to 5% in 1997. The consumption-tax-hike in 1997 worsened the recession, deflating the economy. Since the people were discouraged from spending, retail businesses experienced lower prices. The decline in retail sales was followed by a decrease in nominal wages. The nominal GDP growth rate lowered to −1.8% in 1998, and the unemployment rate rose to 4.1%. Due to the huge crashes in stock market, increasing govt. deficit, high debt to GDP ratio, lack of significant investments, decline in living standard, high unemployment and absence of any real growth rate despite the very low interest rates the years since 1991 have been labelled as the “Lost Decade”. This situation of Japan has been described differently by various economists. Some view it as a case of great recession, some as huge deflation whereas some others such as Paul Krugman have emphasized on the fact that Japan has entered the so called “Liquidity trap”. It is a situation where even the constant infusions of money into the market by the central bank is unable to lower the interest rate further and consequently fail to stimulate economic growth. The indicators of a liquidity trap are near zero short term interest rates and change in monetary supply which fails to bring about any change in the general price levels i.e. fail to cause inflation. A liquidity trap is caused when people start saving cash immensely due to the expectation of an adverse event in the future such as deflation, insufficient aggregate demand or an event of war. If people have low expectations about their future incomes then even with a zero interest rate they tend to save more than the economy can absorb. And consequently, no matter what the central bank does with the money supply, it
cannot bring about inflation in the economy sufficiently to restore full employment. Thus it is a classic case in which the economy „needs inflation‟ in order to recover and function efficiently. We can visualize the condition of a liquidity trap by the IS-LM approach by drawing a simple graph as follows:
From the IS-LM graph it is evident that changes in the monetary policy are absolutely ineffective to tackle the situation of liquidity trap....
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