Japan's Negative Risk Premium in Interest Rates: The Liquidity Trap and the Fall in Bank Lending

25 Pages Posted: 6 Jun 2003  

Rishi Goyal

International Monetary Fund (IMF)

Ronald McKinnon

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

Abstract

Japan's interest rates have been compressed toward zero because of pressure coming through the foreign exchanges. Twenty years of current-account surpluses have led to a huge buildup of claims - mainly dollars - on foreigners. Because of ongoing fluctuations in the yen/dollar exchange rate, Japanese financial institutions will only willingly hold these dollar claims if the nominal yield on them is substantially higher than on yen assets. In the 1990s to 2002 as US interest rates have come down, portfolio equilibrium has been sustained only when nominal interest rates on yen assets have been forced toward zero. One consequence is the now infamous liquidity trap for Japanese monetary policy. A second consequence is the erosion of the normal profit margins of Japan's commercial banks, leading to a slump in new bank credit and an inability to grow out of the overhang of old bad loans.

Suggested Citation

Goyal, Rishi and McKinnon, Ronald, Japan's Negative Risk Premium in Interest Rates: The Liquidity Trap and the Fall in Bank Lending. The World Economy, Vol. 26, pp. 339-363, March 2003. Available at SSRN: https://ssrn.com/abstract=411350

Rishi Goyal

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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)

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