Project Work

in the university course

International Finance B.Sc.

Topic

Escaping from a liquidity trap

submitted by:

Flemming J. Coombs
Camilo A. Echeverri
Julian Martin
Herzogstrae 22 63263 Neu Isenburg
Thomasiusstrae 5 60316 Frankfurt am Main
Kurhessenstrae 95 60431 Frankfurt am Main

Matrikel-No.: 1130924
Matrikel-No.: 1138081
Matrikel-No.: 1123180
****************

Prfer: Emmanuel Benjamin

Abgabedatum: 16.06.2017
Table of Contents
1. INTRODUCTION .................................................................................................................................... 3

2. LIQUIDITY TRAP ............................................................................................................................... 3

3. DEFLATION ......................................................................................................................................... 5
4. THE ZERO LOWER BOUND ............................................................................................................. 7
5. CASE STUDY: JAPANS LIQUIDITY TRAP .................................................................................. 9
5.1 JAPANS ASSET-PRICE BUBBLE ....................................................................................................... 9
5.2 BANKING CRISIS .................................................................................................................................. 10
5.3 FROM SMOKE TO SMOTHER ................................................................................................................. 10
6. ESCAPING THE CYCLE OR HOW TO GET OUT OF THE LIQUIDITY TRAP.................... 10
6.1 INFLATION............................................................................................................................................ 11
6.2 FISCAL POLICY..................................................................................................................................... 11
6.3 BANKING REFORM ............................................................................................................................... 11
6.4 POLICY MIX ......................................................................................................................................... 11
7. CONCLUDING REMARKS .............................................................................................................. 12
8. REFERENCES .................................................................................................................................... 12

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 II. Image Index
Figure 1: Economy at nominal rate of zero......................6

Figure 2: Aggregate demand shock......................7

III. Acronyms

CPI GDP deflator

Consumer Price Index .................................... 7 Gross domestic product deflator ..................... 7
ECB U.S
European Central Bank ................................... 8 United States .................................................. 4

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 1. Introduction

The concept of the liquidity trap has been around for a long time, but it wasnt really discussed and
analysed until the U.S had to go through one of the biggest economic crisis in modern history, the
Great Depression. Sir John Maynard Keynes was one of the first economists that introduced the
concept of the liquidity trap by taking old arguments regarding deflation, modifying them and
coming up with a whole model to explain this rare but complicated economic condition. After the
model was introduced by the Keynesians (specifically John R. Hicks) it seemed to be declared
extinct, since it was not a topic of research and it couldnt be linked with any of the economic
events of the time. However, by the end of the 1980s, Japan drifted into a big slump, which
evolved into a liquidity trap. All of the sudden, this alleged extinct dinosaur, was back and had a
firm grip on the Japanese economy (Krugman, 1998). During this process, many new aspects of
the liquidity trap were discovered, so modern liquidity traps theorist such as Krugman and
Bernanke could further develop the model and come up with different approaches on how to
manage it.

This Project work offers an insight into the world of the liquidity trap by introducing different
concepts relevant for the analysis of this type of economic condition. This paper also tries to define
deflation, the zero-lower bound and how the expectations of economic agents are directly
correlated with the capability of an economy to get out of a liquidity trap. Finally, a brief historical
view of the Japanese liquidity trap is presented, in order to show to what extent such an economic
condition can shake and stagnate a whole economy, and which economic policies can be used in
order to get out of it.

2. Liquidity Trap

When the production level is lower than its natural level, the central bank operates an expansive
monetary policy. This makes the nominal rates fall. (Blanchard & Illing, 2014) If the nominal interest
rate is zero or near zero, expansive monetary policy seizes to generate an effect on the economy.

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We are in a liquidity trap: the economic subjects are holding their money rather than investing it
(Blanchard & Illing, 2014).

An increase of the monetary base by the central bank, would not help the economy because people
will expect the nominal interest rate to rise and the prices of securities to fall so they would hold
their money for future investments. Because of this, money falls into a liquidity trap (Blanchard &
Illing, 2014). At this stage, the possibilities of the central bank are limited because the nominal
interest rate cannot be set below zero. On the other side, if the expected inflation is low or even
negative (deflation), the real interest rate would be too high to help the economy out of recession
(Blanchard & Illing, 2014). In order to understand how inflation affects the real interest rate, the
following formula has to be introduced.

r = i - e
The real interest rate (r) equals the nominal interest rate (i) minus the expected inflation (e).
(Blanchard & Illing, 2014) This equation introduced by Irvin Fisher illustrates the implications of a
liquidity trap. A nominal interest rate of zero is a rate which should suffice to stimulate the
expenditures strongly and keep the economy out of a recession. But it does not suffice. The reason
why it does not suffice can be explained by the fisher equation. If the expected inflation rate is
high, for example 10%, a nominal interest rate of zero equals a real interest rate of -10%( r = 0
10%). When the real interest rate is that low, consumer spending and capital expenditure go up and
output gets pushed back to its original level. In this case, a high inflation rate is not a serious
problem. However, if we assume that the inflation rate is negative, for example -5% (the economy
has a deflation-rate of 5%) the effects on the economy could be catastrophic. At a nominal interest
rate of zero, the real interest rate will be 5%. Expenditure will not be stimulated and since the
nominal rate is already at zero, there is noting that the traditional monetary policy can do to
increase the production level, (the reasons why this happens will be explained at a later point).
Therefore, deflationary expectations that make the real interest rate be positive while the nominal
rate remains at zero, can lead to a serious economic crisis (Blanchard & Illing, 2014). To have a better
understanding of this problem, lets have a look at the following IS-LM model:

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 Consider that the economy is currently at point A. This
point describes the equilibrium between the money
market and the goods market and is defined by the
intersection of the IS- and LM-Curves. The nominal
interest rate i is zero and the production level Y is
below its natural level Yn. To overcome this problem,
the central bank could lower the nominal interest rate to
increase investment and consumption. However, since
the nominal rate is at 0, there is nothing traditional
monetary policy can do. Since the production level is below its natural level, the deflation rate will
continue to rise. Therefore, the real interest rate will rise as well. The IS-Curve moves to the left
from IS to IS and the production level gets be pushed from Y to Y. This will make the deflation
rate and the real interest rate rise, which makes the production level fall even more until the point
where the economy gets into a vicious circle. (Blanchard & Illing, 2014)

3. Deflation

After introducing the concept of the liquidity trap, it must be analyzed which type of economic
conditions have to be fulfilled, in order for an economy to reach such state. Since World War II,
inflation has been regarded as the bane of central bankers (Bernanke, 2002). However, its counterpart
deflation, has been regarded as their biggest phobia.

At any time of the economic cycle, especially in a low inflation economy, the prices of different
goods and services will be decreasing. (Bernanke, 2002). This occurs because the productivity of
specific sectors is increasing, which makes their costs decrease at a faster pace, or simply because
the demand for the output of these sectors is lower than the demand evidenced in other areas of the
economy. (Bernanke, 2002) These sector specific price declines are normal and cannot be regarded as
a danger for the economy.

Nevertheless, the economy could be facing a period of deflation, if the price declines are so
widespread that the broad-based price indexes get affected as well. (Bernanke, 2002).

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According to the International Monetary Fund, deflation is defined as a sustained decrease in any
type of aggregate measure of prices such as the Consumer Price Index (CPI) or the Gross
Domestic Product deflator (GDP deflator). (IMF, 2003) If the price decline lasts from one up to two
quarters, there is no reason for the central bank to worry. On the other hand, a mild but constant
deflation could be a cause of concern, since it increases economic uncertainties, affects the
allocation of resources and the overall growth of the economy (IMF, 2003).

Modern economies are reigned by a Fiat Money System, under which governments can issue an
unlimited amount of money by interacting with the capital markets. (Goodhart & Hofmann, 2003)
Under these conditions, deflation is unconceivable. However, the Great Depression of 1929 and
the decline in Japanese equity and land prices during the nineties, demonstrated that collapses of
the aggregate demand, caused by a large decrease in the asset prices and severe spending cuts, can
be associated with deflation and can have deep repercussions on the functionality of the whole
economy. (IMF,2003)

The determinants of deflation can be analyzed using

macroeconomic tools based on the ADAS model.
Consider that the economy is at a full employment
Equilibrium (Y*) which is described by the
intersection of the aggregate demand (AD) and the
aggregate supply (AS) (IMF, 2003). A severe aggregate
demand shock, shifts the aggregate demand curve to
the left from AD to AD, which sinks the price level,
lowers Output and pushes the economy into a
deflationary region **, Y** (IMF, 2003). As stated before, this shock could be generated by the
burst of an asset bubble, a severe cyclical downturn or excessively tight policies (IMF, 2003).

A deflationary shock can be exacerbated by the decrease in the confidence and expectations of the
economic agents, which will postpone their expenditures and make the demand fall even further.
This idea introduced by Keynes is one of the crucial arguments to explain the failure of monetary

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policies in such scenarios, and sets the groundwork to explain the causes of a liquidity trap.
(Keynes, 1923)

Going back to the introduction of the liquidity trap, a deflation of sufficient magnitude could make
the nominal interest rate sink to 0, which is called the zero-lower bound. Once the nominal rate is
at 0, it is not possible to make it negative because lenders would prefer to hold cash rather than
paying borrowers to lend money. (Bernanke, 2002) The nominal interest rate being close to zero
generates special problems for the economy and the monetary policy. At the lower zero bound, the
real interest rate equals the expected rate of deflation. This translates to a general decrease of
prices and an increase of the real rate in the same magnitude; the higher the deflation, the greater
the real interest rate (IMF, 2003).

While central banks are the ones that control the short-term nominal interest rate, many economists
believe that the real interest rates are the ones that influence economic progress and activity.
(Blinder, 2006). In a deep recession, the central bank would try to make the real interest rates
negative but it wouldnt be able to accomplish this, because the rate of inflation is 0 or negative
and the lower zero bound has already been reached. In this scenario, classic monetary policy tools
will become irrelevant and the economy will find itself in a liquidity trap. For a long time,
economists disregarded this issue as a pure theoretical scenario. Nevertheless, the economic
downturn that japan has suffered the last 20 years, accompanied with the low interest policy of
different central banks across the world, specifically the ECB, have made deflation and the
liquidity trap a (very) relevant topic that cannot be ignored (Blinder, 2006).

4. The zero-lower Bound

The zero-lower bound is one of the defining concepts of the liquidity trap and therefore it must be
analyzed thoroughly. As stated before, the short-term nominal interest rate is one of the main tools
that central banks use to control the economy. If the economy is facing a recession, the central
bank will try to incentive it by sinking the nominal interest rates and in that manner increasing
output. If the economy is overheated, the central bank will rise the interest rates, and put a hold on

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output. (Williams, 2014). The zero bound on interest rates hinders the implementation of monetary
policy and enhances the risk of an economy getting caught in a liquidity trap. (ICMB, 2016)

To fully understand the consequences of reaching a liquidity trap, Paul Krugman enhanced the
ISLM framework used in the introduction of this paper and tried to explain the lower bound taking
the expectations of economic agents into account (Krugman, 1998).

The liquidity trap involves a clear credibility and expectations problem. The following model uses
these intertemporal aspects to understand the relationship between the lower zero bound and the
liquidity trap. Consider a one good economy with a cash in advance constraint. This constraint
means that economic agents must go through a two-step process every period. At the beginning of
each period they can exchange their cash for bonds with an interest rate r. Their consumption for
that period is constrained by the remaining cash they hold after the completion of the exchange.
The amount the agents consume cannot exceed their money holdings.

As long as the nominal interest rate is positive, the agents will hold the needed cash to make their
purchases and the cash constraint will be binding (Krugman, 1998).

The next assumption that Krugman makes is that from the second period onward, both output and
consumption will remain constant at Y* (level of full employment) and the government will hold
the money supply constant at M*. Finally, it is assumed that during period one, production is at its
maximum capacity and that the output is determined by consumption and not the other way
around (Krugman, 1998).

Increasing the monetary supply in an effort to make the economy grow, can increase output until
the nominal interest rates have reached the zero-lower bound. An increase of the monetary base
over that bound, will make the extra money be exchanged for zero bonds, consumption will remain
unchanged and money will become irrelevant. Money will become irrelevant because the
economic agents expect deflation, considering that the short run price P is higher than the long run
Price P*, which makes the rate of deflation (P*/P) go down and the real interest rate go up
(Krugman, 1998). At this point, the real cost of borrowing will increase and spending will get even
more restrained (ICMB, 2016)

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On the other side, the agents expected real income is lower than the current consumption amount
needed to satisfy the excess production capacity, so they will prefer saving their money to prepare
for the uncertainty of the future (Krugman, 1998).

This analysis has proven, once again, that if the interest rates are at the zero-lower bound and
negative expectations overwhelm the market, there is nothing that central banks can do to boost
economic growth and reach a full employment level using traditional monetary policy tools.
(Bernanke, 2003). The following chapter takes Japan as an example to show the incapability of
central banks to react while being trapped by the zero-lower bound.

5. Case Study: Japans Liquidity Trap

The bursting of the twin equity and real estate price bubbles in Japan during the 1980s was the
seed for an economy crisis which lasted for 20 years. During this period, Japan went from a
disinflation to a deflation regime (Krugman, 1998).

5.1 Japans Asset-Price Bubble

Both the Japanese equity- as well as the real estate prices tripled in the second half of the 1980s.
At the end of the last business day of 1989, equity prices peaked and real estate prices entered a
correction period. This transition was a sign that these markets were coming back to their pre-
inflated levels. Actions in form of a cleansing view, were taken to accelerate that adjustment.
The cleansing approach consisted of an increase of the nominal interest rate, a new ceiling on real
estate lending, an increase of the capital gains tax and the introduction of a national land-holding
tax. It soon turned out that the decline of these markets, reinforced by the popular cleansing
view, lead to a dramatical fall in the general prices and gave the Japanese economy a very hard
time (Bean et al., 2016).

Two severe mistakes were made by introducing the cleansing approach. One was that market
participants changed their expectations regarding the future and started selling their assets. The
other severe mistake was the underestimation of non-performing loans. It turned out that a
growing number of companies and private households were defaulting on their loans. When a huge

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number of customers cannot repay their loans, a banking crisis is right around the corner (Krugman,
1998).

5.2 Banking Crisis

The loans default rates skyrocketed and a growing number of smaller financial institutions started
going bust. In 1997 three of Japans most relevant banks failed: Hokkaido Takushoku Bank,
Yamachi Securities and Sanyo Securities. The failure of these institutions just worsened the crisis.
It can be seen in nearly every banking crisis, that the failure of large institutions related to the
financial sector creates an atmosphere of mistrust. This mistrust resulted in an increase of
pessimism, a decrease of the economic agents expectations, a sharp decline of investments and a
general weakening of the economy (Bean et al., 2016).

5.3 From Smoke to Smother

The persistent recession of the Japanese economy had taken inflation into a negative territory,
thereby forcing the Bank of Japan to cut the policy rate nearly to zero percent and try offsetting the
decline in prices with an increase of spending. At this point, the economy switched from a
disinflationary- to a deflationary regime that lasted about twenty years. From that point in time, the
Japanese central bank was not able to do further counter-cyclical cuts to the nominal interest rate.
Going back to previous chapters of this paper, when the nominal rate is close to zero and prices are
subject to deflation, inflation expectations become negative and the real interest rate starts going
up. The higher real interest rate increases the weakness of the aggregated demand, which at the
same time increases the downward pressure on prices. (Bean et al., 2016) This translated into an even
bigger crisis and a stagnation of the Japanese economy.

6. Escaping the Cycle or How to Get out of the Liquidity Trap

The way to escape the trap, depends on the circumstances which trapped the economy in the first
place. For this reason, there is no guide on how to keep a country out of such situation. There are
three key factors that influence the outcome of a liquidity trap. One measure alone cant be the
cure for the problem but, combined in the right way and at the right time, they can get an economy
out of the liquidity trap (Krugman, 1998).

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 6.1 Inflation
The first key factor is the regulation of inflation. But how is it possible to influence inflation, when
an increase in money supply is pointless? The central bank should credibly convey that it is
pursuing inflation where it is possible, so that inflationary expectations can be increased. The best-
case scenario is when inflationary tendencies are pushed to a state where monetary policy gains
back its traction (Krugman, 1998).

6.2 Fiscal Policy

A classic remedy for a liquidity trap is fiscal expansion. During a fiscal expansion, the state tries to
stimulate the economy through government spending in the form of public works or by granting
tax cuts. To create a spending environment that matches the rising inflation, the state could
alternatively set up an explicitly temporary investment tax credit (Krugman, 1998).

6.3 Banking Reform

The stability of the financial sector is essential for a healthy economy. In order to grant this
stability, reforms are necessary. The decision regarding where and when these reforms should take
place, depends on each individual case. (Krugman, 1998). In the case of Japan, the bold regulating
policies introduced by Shinzo Abe were the ones that helped the country get out of this never-
ending crisis.

6.4 Policy Mix

It must be pointed out, that there isnt a unique remedy for a liquidity trap. The action plan has to
be accordingly adapted to the economic conditions of the country being analysed. One potential
strategy could be a policy mix based on the key tools presented in thischapter. As an example, a
large fiscal expansion, with interest rates fixed at zero, should be introduced and sustained even
when inflationary tendencies are noticeable. As soon as inflationary expectations dominate the
economic outlook, fiscal expansion can slowly be reversed until the expectations are able to take
up the slack. As soon as inflation is at its necessary level, monetary policy can be used to stabilize
the economy. This process must be accompanied by a healthy banking system which is the
foundation for the success of any economic approach (Krugman, 1998).

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 7. Concluding Remarks

This paper pointed out the effects and consequences of a liquidity trap - a concept that once played
a major role in macroeconomics, but had disappeared from the economic discourse for a long time
(Krugman, 1998). One of the main causes for a liquidity trap is deflation. Therefore, it has been
regarded for many years as the biggest phobia of central bankers. An economy that has been hit by
a demand shock, can be pushed back by the central bank through the implementation of monetary
policy. However, as soon as the interest rate reaches its lower bound, the central bank runs out of
tools to wind up the economy using traditional methods. At the zero-lower bound, the economic
outcome is determined by the capability of central banks to increase spending. With the absence of
nominal rates, the situation turns out to be problematic. When the rates are at their lower bound,
spending is determined by expectations, but during such an economic shock, expectations tend to
be deflationary.
A liquidity trap can be an utterly complex macroeconomic problem, hence there is no sample
solution to escape from it. The measures to overcome such a trap should be adjusted to the specific
economic conditions that the economy is facing. Nevertheless, a policy mix composed of both
fiscal and monetary policy, can be considered as the guide to get out of the labyrinth named
liquidity trap.

8. References

Bean, C., Broda C., Ito, T. & Kroszner, R. (2016) Low for Long? Causes and Consequences of
Persistently Low Interest Rates, Geneva Report on the World Economy 17. CEPR Press,
London.

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Bernanke, B., 2002. Deflation- making sure "it" does not happen here , Washington D.C: s.n.

Blanchard, O. & Illing, G., 2014. Makrokonomie. 6. ed. s.l.:Halbergmoos.

Blinder, A., 2006. Monetary Policy Today: Sixteen Questions and about Twelve Answers , Madrid:
Princeton University and Promontory Financial Group.

Goodhart, C. & Hofmann, B., 2003. Deflation, London: s.n.

ICMB, 2016. Low for Long? Causes and Consequences of Persistently Low Interest Rates,
Geneve: International Center for Monetary and Banking Studies.

IMF, 2003. Deflation: Determinants, Risks, and Policy Options, s.l.: International Monetary Fund.

Keynes, J. (1937). The General Theory of Employment, Interest, and Money. Cambridge.

Krugman, P. (1998) Its Baaack: Japans Slump and the Return of the Liquidity Trap, Brookings
Papers on Economic Activity , 2

Williams, J., 2014. Monetary policiy at the zero lower bound, San Francisco: Brookings.

Declaration of Authorship

We hereby certify that this thesis has been composed by us/

me and is based on our/my own work, unless stated

otherwise. No other persons work has been used without

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due acknowledgement. All references and verbatim extracts

have been quoted, and all sources of information, including

graphs and data sets, have been specifically acknowledged.

The thesis has not been published or submitted on any other

occasion then in the current context.

Date: _____________Signature(s): ________________________

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