Basically, Japan after the bubble burst experienced steadily falling inflation which eventually became deflation cut interest rates repeatedly eventually, hitting zero and remained depressed. Now, the blue line is real GDP per capita it didn't actually have a plunge at any point being a fast growing economy up to the end of the `80s. Japan basically, stagnated in terms of real per capita GDP with a few Wiggles. That's the infamous last decade in Japan One thing that I've been saying lately is that in light of what we've been going through- in all the world including Japan these last few months- Japan's lost decade is starting to look pretty good. There was no mass unemployment there was no extreme plunge in the economy, But it was certainly frustrating. -They slid into a recession that basically, never ended what was worse it was unresponsive -They slipped into a into an infection that was resistant to the usual antibiotics That was a deeply alarming thing: Japan in his last decade was not a terrible place to live; It was not mass unemployment, It was not blood in the streets, but it was intense prolonged frustration of the inability to get that economy moving again. I wasn't alone obviously, in thinking about the Japanese example; I at least said Japan basically, looks a lot like us. If they can be caught in the trap like this for an extended period Why, can't it happen to to other countries? So there were a number of people worrying about that. It was on people's mind as a possibility, And the thing is it the it came true, we got into a situation of overextension excessive leverage and the mother of all housing bubbles. When all of that burst we were plunged into a recession- and the Fed had thought about how to deal with something like a Japanese trap- Their first rule was cut interest rates early and often basically, aggressive, initial monetary policy response which they did. But it wasn't enough and went all the way to zero ,and the economy is still shrinking found themselves in the liquidity trap.
Now, this is where we begin the Alice Through the Looking class discussion a situation where short term interest rates are zero. Normally, monetary policy is made by cutting a target interest rate where you've gone all the way to the end of that that was named the liquidity trap. Meaning that you can normally increase the quantity of money. That means that people have more liquidity than they need, they lend it out, you get sort of chain reaction through the credit markets, that helps to expand the economy, But if interest rates are zero, people are saturated, they have as much liquidity as they want. This was advanced not in those words, but it's advanced as a central theme in Keynes's General Theory. It was somewhat formalized by john Hicks, but it's sort of vanished from consideration In economics you can actually sort of see why, But when something like it arrived in Japan and now, for all of us today a lot of people found it hard to believe that there was a widespread belief, that well look if the central bank prints a bunch of money that has to have an expansionary effect on the economy. In fact, it has to be inflationary I mean, we just know that printing money is inflationary. We have this, standard way that we do short term macroeconomics, the is model, but everybody who does that knows that it's ad hoc, “It's not really grounded in micro foundations” all these things that economists say, And presumably if you thought about it really carefully, and dotted all your I's and crossed all your T's, you would come to the conclusion that of course expanding the money supply is effective no matter what. And to my shock it actually gave me the opposite answer, "Liquidity trap can be real it really can be true that that printing money has no effect." On the reason once you think about it is pretty clear. Really, once you for whatever reason have gotten a situation where short term interest rates are zero Well, then you go and do conventional monetary policy. What is conventional monetary policy central bank prints some money; or more accurately credits banks with more reserves and buys up a bunch of treasury bills short term government debt
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