Japan's stagnant 1990s : The role of the liquidity trap

The work has two objectives.First, it presents the theories that compete to explain Japan's sluggish economic development in the 1990s.The discussion aims at finding the most influential theories and at drawing conclusions on their validity during the decade-long economic stagnation.The second objective is discussing the liquidity trap, or more broadly the zero interest trap, in the context of Japan.The work compares the traditional definition with a more up-to-date version of the trap and treats the different methods of escaping from the zero interest rate trap.The explanations for the stagnant 1990s are analysed through a literary survey.The liquidity trap discussion is likewise based on various sources, although Krugman's models are given a central role.In accordance with Krugman's liquidity trap theory based on a negative equilibrium real interest rate, Japanese real interest rates are studied through structural time series models.The means of escaping from the trap are discussed first theoretically and then from the viewpoint of the Bank of Japan.The results indicate that the significance of the competing theories has varied during the 1990s.Demand related issues are found crucial, as unwinding of the capital overhang, liquidity trap, credit crunch, mistaken macroeconomic policy and external shocks have decreased aggregate demand.Particularly, the structural time series analysis implies that the equilibrium real interest rate may have been negative at times during the late 1990s.As to escaping from the liquidity trap, inducing inflation expectations and depreciating the domestic currency are found efficient in theory.However, the nature of the Japanese economy might restrict their effectiveness in practise. The ability of the Bank of Japan to affect private sector expectations is repeatedly revealed crucial.Key words: Japanese economy, economic stagnation, liquidity trap, real interest rates