1. Introduction

The Japanese economy has stagnated and deflated in nearly a decade. Svensson (2003) summarizes that two factors that cause Japan to fall into a trap are policy errors and a lack of policy coordination to recover the Japanese economy.

There are some debatable arguments related to Japanese policy for escaping Japan from the liquidity trap. One of the debates comes from Krugman who said that the Japanese economy has fallen into a liquidity trap. It highlights the importance of a negative real interest rate to balance the economy, to equalize saving with investment in Japan.

This paper will outline Krugman’s point of view on his article “Japan: Still Trapped”, and will give an opinion on his argument that a negative real interest rate is necessary to restore full employment. This paper will also relate Cagan’s stability model to Krugman’s analysis and will point out the role of fiscal policy in maintaining the stability of the Japanese economy.

2. An overview of the Japanese economy and Krugman’s argument

Since 1990, Japan has fallen into stagnation and deflation of the economy. There are several causes that keep Japan in recession. A high savings rate and a low consumption rate in Japan, for example, have caused a terrible drop in demand and made it difficult for Japan’s economy to recover. In addition, the appreciation of the yen against the dollar has also been a serious problem that caused the economic bubble, the deflation of asset prices and the liquidity trap. (Okimoto, 1999)

Krugman reveals some facts that Japan caught in a trap, such as: the low short-term interest rate that has reached almost zero, the BOJ’s actions to stimulate demand by lowering the interest rate are ineffective and some transactions of money grabbing. To explain the economic situation in Japan, he began his analysis based on the basic IS-LM model. (1) (2)

According to the first equation, saving (S) and investment (I) depend on the level of real income (y) and the real interest rate (r). Meanwhile, in the second equation, i is the nominal interest rate, the real rate plus expected inflation.

He argues that the concept of liquidity trap occurs when saving exceeds investment at full employment even at zero real interest rate. In the graph above it can be clearly seen that the solution for the interest rate to equal savings and investment in full employment is a negative real interest rate. This is the critical point for Krugman to emphasize the importance of the negative real interest rate in restoring full employment. From this point of view, he argues that, given the zero interest rate, a positive expected inflation rate is needed to generate negative real interest rates, which will stimulate aggregate demand and restore full employment.

3. Criticisms of Krugman’s argument

To understand Krugman’s argument, it is better to review the concept of the liquidity trap. What makes Krugman incomprehensible has to do with the distinction between cost and return on capital. Rogers (na) argues that Krugman does not clearly explain the distinction between cost and return on capital. Furthermore, he also believes that Krugman’s concept of getting out of the liquidity trap by setting a negative cost of capital to match the negative return on equity does not make economic sense.

From Roger’s idea, what is important for the Japanese economy to get out of the liquidity trap and recover the economy is the positive marginal efficiency of capital (MEC). It means that to induce a new investment, the rate of return on cost must exceed the interest rate. Thus, since the difference between what is returned and the costs constitutes the profits, to induce a new investment, the rate of profit (marginal efficiency of capital / MEC) must exceed the interest rate.

Roger also reveals the relevance of Wicksell’s theory to recovering the Japanese economy. This idea is understandable because if the money interest rate were below the natural rate of return on capital, people would borrow at the money rate to buy capital, thus increasing the demand for some resources and also their prices. In this terminology, price stability would occur only when the money interest rate and the natural rate of return on capital, the marginal product of capital, were equal.

4. Convergence condition of Cagan and Japanese economy

To simplify an economic instability in Japan, I will use a Cagan convergence condition, which Cagan developed in 1956. He has developed a hyperinflation model by deriving this condition, as shown below. (3. 4. 5)

We can substitute for the equation. Then. From the first equation, we substitute and discard the variables that are not involved in this convergence analysis, so we establish. Therefore, we can apply those equations to the matrix.

To solve simultaneous differential equations, the necessary and sufficient conditions for stability are that the determinant of the 2×2 matrix is ​​positive and that the trace is negative. Therefore, you must be satisfied, or so.

In the early 1990s, the Japanese economy fell into the property and stock price bubble. In such a liquidity trap situation, the interest elasticity of money demand is expected to be so high. Also, the ZIR policy of the Bank of Japan Then would set the nominal interest rate almost to zero. Another component of the cagan model (expectation of adjustment of the speed of people) is likely to increase, so, based on the condition, the Japanese economy is expected to be unstable and will fall into a deflationary spiral.

This term -deflationary spiral- can clearly be explained by Svensson (2003) that the deflationary situation would give a negative consequence to the Japanese economy. First, the deflationary situation would increase the real value of the nominal debt, which could lead to the bankruptcy of some indebted households and companies and the fall in asset prices. Furthermore, these problems would trigger instability in the financial system as banks would face losses in the value of collateral and bad loans.

It also reveals that instability in the Japanese economy is deteriorating with a deflationary spiral due to a rising unemployment rate in the Japanese economy and a sticky wage. In this case, due to deflation, real wages would not fall, but would rise, further increasing the unemployment rate. However, this may contribute to a further decline in aggregate demand, a further rise in deflation, and a further rise in the real interest rate.

5. The role of fiscal policy in Japan

The role of fiscal policy in escaping the Japanese economy from a liquidity trap is still debatable. Although some people might argue that expansionary fiscal policy is powerful to be a stabilization policy when the economy goes into recession, to restore full employment in a liquidity trap. This policy, instead, has led Japan to a huge national debt. In fact, Krugman (1998) pays almost no attention to the role of fiscal policy in Japan. He argues that fiscal policy would have no effect if consumers actually exhibited something like Ricardian equivalence. In this case, people would anticipate a policy of higher public debt by increasing their savings, because they expect a tax increase or a reduction in government benefits. Furthermore, he also argues that some tax expenditures in Japan are unproductive to stimulate its economy.