Austerity or growth?

Understanding Benign Liquidity Traps: The Case of Japan

from NCPA,

Stefan Homburg of Leibniz University in Hanover, Germany provides a theoretical model that explains Japan's experiences the last 25 years. This explanation of the limited effect of quantitative easing has serious implications for the Federal Reserve, European Central Bank and Bank of England monetary policies in the post financial crisis period. He introduces a general equilibrium model with a credit constraint. In the presence of near zero interest rates the constraint drives the economy into a liquidity trap. In his model under a binding credit constraint, investment is not restricted by credit costs but by credit availability. Because the limiting factor is credit availability reducing credit costs has no effect on growth and inflation. Ultimately, the two Anglo-Saxon countries and the Eurozone have imitated Japan's policy approach and have obtained similar results. Specifically, all of these countries have reduced nominal interest rates via unprecedented monetary expansions but still experience price stability. According to the view supported here, the only sensible explanation of this concurrence is the existence of a binding credit constraint. So what generates these credit constraints? Financial regulation may be the explanation for constrained credit. The first comprehensive bank regulations, Basel I, became effective in Japan in the early 1990's. At the present, and in the wake of the Financial Crisis, Basel III has taken effect. An alternative explanation stems from the observation that liquidity traps do not presuppose a sudden decrease in credit limits but can also result from a sudden increase in the equilibrium credit level. Therefore, aggressive monetary policies move the economy from a position of unconstrained credit into a shortfall of available credit if the supply of credit is unable to adjust due to accounting conventions, regulatory burdens or sluggish collateral prices. Homburg stresses that such credit constraints may be more important for macroeconomic performance than interest rates.

More From NCPA:

365 Days Page
Comment ( 0 )