Japanese Interest Rates, Liquidity Trap

Japanese Interest Rates, Liquidity Trap

Ans.1 A liquidity trap is characterized by the increase in supply of money by the central bank. This increase in supply of money does not have any effect on output, price level, rates of interest or other variables (Meltzer, n.d.). In economic terms, it is said that monetary polices have no impact on the nominal or real variable interest rates (Buiter, 2001). Modifications in the stock of money are entirely corresponded by modifications in the demand to possess money. The idea of a liquidity trap emerged with John Maynard Keynes during the Great Depression. Keynes speculated that if the rate of interest fell below 2 per cent, then monetary expansion might not function properly. He even identified that a liquidity trap had never happened. In reality, monetary policy was strong at the time of the Great Depression. Deflationary monetary policy was the crucial reason behind economic crash between 1929 and 1933 (Meltzer, n.d.).

Now, the question arises that whether the U.S. is falling into a liquidity trap due to the sub-prime mortgage crises. In early 2007, the term “subprime mortgage crisis” became familiar in United States to depict the decline of the U.S. mortgage market, and failures from mortgage backed securities (MBSs) and securities-based debt obligations (CDOs) supported by sub-prime mortgages (Kirk, n.d). Like Japan, United States have entered into a liquidity trap with approximately zero rate of interest (Letters: Liquidity trap? 2008). According to Paul Krugman, an economist and a Novel Prize winner, the Federal Reserve Bank funds rate is normally very near to the rates of interest on US government debt. However, the early 2008 had seen the situation where yield of Treasury bills were considerably less than the Federal Reserve funds rate. This prevented banks from lending each other. There was no allurement to lend out in the monetary foundation as the rate of interest which one would have got was not adequate...