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The Foreign Exchange Origins of Japan's Economic Slump and Low Interest Liquidity Trap

HKIMR Working Paper No. 05/2000

37 Pages Posted: 28 Aug 2007  

Ronald McKinnon

Stanford University, School of Humanities & Sciences, Department of Economics (Deceased); CESifo (Center for Economic Studies and Ifo Institute for Economic Research) (Deceased)

Kenichi Ohno

affiliation not provided to SSRN

Date Written: August 2000

Abstract

Japan's macroeconomic problem has yet to be properly diagnosed. Throughout the 1990s, policy makers could not decide on the proper macro economic measures to combat the country's severe economic slump. We propose a unified explanation, with deep historical roots, of why aggregate private demand failed to recover after Japan's stock and real estate bubbles burst in 1991 and deflationary pressure continues.

The problem is not purely "made in Japan". It arises from Japan's unbalanced mercantile relationship with the United States. Starting in the early 1970s, numerous trade disputes between the two countries created tensions that were (temporarily) resolved by the yen going ever higher against the dollar up to 1995. In the last two decades, this persistent pressure for the yen to rise was further aggravated by Japan's large current-account (saving) surpluses as the counterpart of America's large current account (saving) deficits. The legacy is the expectation that trade and financial tensions will recur so that the yen will be higher 10, 20, or 30 years from now - with Japan's (wholesale) price level forced correspondingly lower and nominal interest rates on yen assets remaining more than four percentage points less than those on dollar assets.

This fear of yen appreciation, whose timing is erratic and unpredictable, now inhibits private domestic investment by both Japanese firms and households. Our theory also explains why, in the late 1990s, nominal interest rates on short-term yen assets were compressed toward zero so as to destroy the normal profit margins of the banking system. In this liquidity trap, the Bank of Japan-whose monetary policy has been quite "expansionary" - is powerless to stimulate the flagging economy.

To spring the liquidity trap, eliminate deflationary pressure, and restore macro economic balance in Japan, the American and Japanese governments must act jointly to quash the expectation that the yen will be higher in the future than it is today.

Suggested Citation

McKinnon, Ronald and Ohno, Kenichi, The Foreign Exchange Origins of Japan's Economic Slump and Low Interest Liquidity Trap (August 2000). HKIMR Working Paper No. 05/2000. Available at SSRN: https://ssrn.com/abstract=1009485 or http://dx.doi.org/10.2139/ssrn.1009485

Ronald McKinnon (Contact Author)

Stanford University, School of Humanities & Sciences, Department of Economics (Deceased)

CESifo (Center for Economic Studies and Ifo Institute for Economic Research) (Deceased)

Kenichi Ohno

affiliation not provided to SSRN

No Address Available

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