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Trapped
Subject Monetary Policy
Topic International Finance
Key Words Interest Rates, Economic Growth, Exchange Rates
News Story

The dilemma for Japan's policy makers is how to revive an economy where prices and economic growth continue to fall even with interest rates at almost zero. Slack demand has lead to decreased prices, and falling prices cause firms to cut expenditures. The result is that nominal output decreased at an annual rate of 10% in the second quarter and many economists are predicting that Japan's economy will suffer a contraction even worse than the one in 1998.

John Maynard Keynes, writing during the global Depression of the 1930s, discussed a "liquidity trap," a period where consumer confidence is so weak, and uncertainty so great, that people would rather hold cash than debt no matter how low interest rates become. If an economy is in a liquidity trap, monetary policy becomes ineffective. The key overnight rate in Japan, the rate that Japan's central bank charges other banks to borrow money overnight, has fallen to 0.001 percent. Even at this low rate, many borrowers are paying down old debt rather than finance new expenditures. According to a survey, only 9 percent of Hiroshima-area firms plan to borrow for investment.

Some economists have proposed inflation as a remedy for the liquidity trap. The theory is that if prices were to rise at a significant rate with interest rates lagging behind, the real cost of borrowing would be negative. Consumers and business firms might be eager to take out new loans at negative real rates. Japanese Finance Minister Masajuro Shiokawa is reluctant to do that. He argues that reducing interest rates to virtually zero and increasing the money supply is sufficient risk for the economy. Inflation is a process, “whose fires will spread and could even burn furiously.”

Other remedies have been proposed. Many are calling for Japan to purchase large numbers of dollars. This action will devalue the yen, thereby increasing the money supply. Both of these actions will raise prices. Many Japanese now think fondly of the days when coffee costs $6 a cup, and melons sold for $100 each. In the old days of rising prices, the economy was rising as well.

(Updated December 1, 2001)

Questions
1. How do banks make money? What problems arise when interest rates on loans near zero?
2. How is monetary policy supposed to work? That is, how does a decrease in interest rates
stimulate the economy?
3. How would a policy of buying dollars affect the exchange rate? How would changes in the
exchange rate affect prices?
4. What is the difference between a nominal and real interest rate? If prices were to rise above
the interest rate on loans, what would happen to the real interest rate?
Source Phred Dvorak, "Can't Give It Away," The Wall Street Journal, October 25, 2001.

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