Liquidity Trap and the Stability of Money Demand: Is Japan Really Trapped at the Zero Bound?


Is the Japanese economy really trapped at the zero interest rate bound? The question seems particularly important because recent theoretical discussions on liquidity traps suggest that undesirable dynamics such as "deflationary spiral" are likely to occur when the economy reaches the lower zero bound. This paper attempts to answer the above question by analyzing the stability of an equilibrium money demand relationship in Japan. Specifically, it performs a formal analysis on the presence and stability of cointegration in M1 demand in Japan and argues that the answer seems negative. With the double-log specification, a cointegrating M1 relationship exists and is found to be stable (i.e. no break in the interest elasticity) even after 1995 when nominal rates were lowered to a decimal point level or virtually "zero percent".

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