Krugman on the Liquidity Trap : Why Inflation Won ' t Bring Recovery in Japan by Jan

The failure of the Japanese economy to respond to aggressive monetary easing in the form of a zero bid rate on the Bank of Japan's overnight financing facility has reminded some economists of Hicks's IS-LM rendition of Keynes's "liquidity trap". Those who use Hicks's famous diagram as the point of reference for evaluating monetary policy will recall that at some low rate of interest the horizontal portion of the LM curve emanating from the vertical axis is meant to represent the lack of influence of expanding the money supply on the rate of interest; monetary policy thus does not shift the intersection of the LM curve with the IS curve that determines the equilibrium level of output. Since monetary policy has no impact on the level of output along this horizontal portion of the LM curve, debt financing of government expenditure remains the only policy capable of influencing output. The explanation that is given of the failure of monetary policy is that interest rates are so low that they cannot be reduced further. In the case of Japan, since moving rates below their current zero bid rate would mean negative rates, it is considered to be the first known example of an economy facing a liquidity trap.