Business Home - A Review on Krugman's Argument - Japan - Still Trapped

Introduction 1.

Svensson (2003) summarizes that two factors which trigger Japan caught in a trap are policy mistakes and a failure to coordinate policies to recover Japanese economy. Japanese economy has caught in a stagnation and deflation in almost a decade.

To match saving with investment in Japan, he highlights the importance of a negative real rate of interest to equilibrate the economy. One of debates comes from Krugman that said Japanese economy has caught in a liquidity trap. There are some debatable arguments related to the Japanese policy to escape Japan from the liquidity trap.

This paper will also relate cagan's stability model to krugman analysis and point out the role of fiscal policy in maintaining stability of the Japanese economy. And give an opinion about his argument that a negative real rate of interest is necessary to restore full employment, this paper will outline Krugman's point of view on his article "Japan: still trapped".

An overview about Japanese economy and Krugman's argument 2.

1999) (Okimoto, And the liquidity trap, asset price deflation, yen appreciation to dollar has also been a serious problem which led to cause the economic bubble, furthermore. Have led to a terrible drop in demand and cause Japan difficult to recover the economy, for example, a high saving's rate and low consumption rate in Japan. There are several causes which make Japan continued to recession. Japan has fallen to a stagnation and deflation in economy, since 1990.

(1) (2) He started his analysis from the basic IS-LM model, to explain the economic situations on Japan. BOJ actions to stimulate demand by lowering interest rate is ineffective and some money hoarding transactions, such as : the low short term interest rate which have reached nearly zero, krugman reveals some facts that Japan caught in a trap.

The real rate plus expected inflation, i is the nominal interest rate, meanwhile in the second equation. Saving (S) and investment (I) are contingent on the level of real income (y) and real interest rate (r), from the first equation.

Which will stimulate aggregate demand and restore full employment, a positive expected rate of inflation is needed to generate negative real interest rates, given zero interest rate, he argues that, in this point of view. This is the critical point for Krugman to stress the importance of negative real rate of interest to restore full employment. It can be clear from the graph above that the solution for the interest rate to match saving and investment equal at full employment is a negative real rate of interest. He argues that the concept of liquidity trap happens when saving exceed investment at full employment even at zero real interest rate - that .

Critiques on Krugman's argument 3.

He also think that Krugman's concept to come out from liquidity trap by setting a negative cost of capital to equate to the negative return on capital makes no economic sense, furthermore. Rogers (n.a) argue that Krugman is not clearly to explain about the distinction between the cost and the return on capital. What make Krugman's is incomprehensible is about the distinction between the cost and the return on capital. Its better to review about the concept of liquidity trap, in order to make an understanding about Krugman's argument.

The rate of profit (marginal efficiency of capital/MEC) must exceed the interest rate, to induce new investment, as the difference between what is returned and the costs constitute the profits, thus. It means that to induce new investment the rate of return over cost must exceed the rate of interest. What is important for Japanese economy to escape from liquidity trap and to recover the economy is the positive marginal efficiency of capital (MEC), from Roger's idea.

Price stability would result only when the money rate of interest and the natural rate of return on capital-the marginal product of capital-were equal, in this terminology. Thus rising demand for some resources and also their prices, people would borrow at the money rate to purchase capital, this idea is understandable because if the money rate of interest was below the natural rate of return on capital. Roger also reveals the relevance of Wicksell theory to recover Japanese economy.

Cagan convergence condition and Japanese economy 4.

(3) (4) (5) As shown below, he has developed a model of hyperinflation by deriving such condition. Which has developed by Cagan in 1956, i will use a Cagan convergence condition, in order to simplify an economic instability in Japan.

We can apply that equations to the matrix, thus. So we set, and drop variables that are not involved in this convergence analysis, we substitute, from the first equation. So. We can substitute to the equation.

Or So, it must statisfied, thus. The necessary and sufficient conditions for stability are that the determinant of 2x2 matrix be positive and that the trace be negative, to solve simultaneous differential equations.

The Japanese economy is predicted unstable and would fall into a deflation spiral, thus from the condition, another component in cagan model (speed people adjustment expectation) is likely to rise. ZIR Policy of Bank of Japan Then would set nominal interest rate nearly to zero, furthermore. The interest elasticity of money demand is to be expected so high, in such situation of liquidity trap. Japanese economy has fall into the bubles economy in property and share price, in early 1990s.

This problems would trigger instability in financial system due to banks would face a collateral loses value and bad loans, furthermore. Deflation situation would increase the real value of nominal debt which may cause some indebted households and firms to bankrupt and fall in asset prices, first of all. This term-deflationary spiral-can clearly explained by Svensson (2003) that the situation of deflation would give a negative consequence to Japanese economy.

A further increase in deflation and a further increase in the real interest rate, this may contribute to a further drop in aggregate demand, all in all. Further escalating unemployment rate, but increase, due to deflation the real wages would not go down, in this case. He also reveals that instability in Japanese economy is deteriorating with a deflationary spiral due to a rising unemployment rate in Japanese economy and a rigid wage.

The role of fiscal policy in Japan 5.

He also argues that some fiscal spending in Japan are unproductive to stimulate its economy, furthermore. Because they expect that there would be a tax increases or a reduction of government benefit, people would anticipate a policy of higher government debt by increasing their saving, in this case. He argues that the fiscal policy would have no effect if consumers really do exhibit something like Ricardian equivalence. Krugman (1998) actually pay almost no attention to the role of fiscal policy in Japan. Has led Japan to a massive national debt, instead, this policy. To restore full employment in a liquidity trap, although some people might argue that Expansionary fiscal policy is powerful to be a stabilization policy when economy goes into the recession. The role of fiscal policy to escape Japanese economy from a liquidity trap is still debatable.