Question

what mix of monetary and fiscal policy is likely to solve the problem of deflation and liquidity trap in Japan since 1990s

Answer 1

Deflation Using Monetary policy: In a period of recession demand in the economy could be growing lesser in the economy as firms leads to reducing the price of overall goods by capturing more customer market in the economy. Therefore increasing the growth of aggregate demand will reduce deflation in the economy.

Central bank could decrease interest rate. Lower interest rate makes borrowing easy and less expensive so that people borrow more loans which leads to more expenditure and investment in the economy which in turn mark the return on economy at higher rate. Lower interest rates would help in

• Increased Exports
• Decreased imports

Second policy Central Bank can use by increasing money supply in the economy which gives more money in the hands of people which gives them more buying capacity where people are ready to buy any product at the price higher than the market price, so it helps in reducing deflation in the economy and helps in increasing the prices of product.

Deflation using Fiscal policy: The government can reduce taxes and increase overall expenditure in the economy. These leads to increased money in the hands of people after paying taxes, which helps in more consumption and more savings, which leads to more investment in the economy through higher savings and more demand for goods when there is more production which increases the prices in the economy.

Liquidation trap through Monetary Policy: It is a case where savings rate are high and interest rates is low making monetary policy ineffective. In this case people keep their money as savings and do not invest in bonds as people always expect that there will be increase in interest rate in the economy which results in lower price of bonds which gives loss to people. Monetary Policy can solve this by increasing interest rates which encourages people to spend and helps banks in getting more revenue in the form of increased interest obtained.

Liquidity trap using Fiscal Policy: Interest rates are zero in Liquidity Trap but aggregate demand is still falling that is the reason governments need to intervene to crowd in investments. The rise in private sector saving needs to be offset by a rise in public borrowing. Thus government intervention can make use of the rise in private saving and inject spending into the economy. This government spending increases aggregate demand and leads to higher economic growth

Diagram to 1st, 2nd and 4th part is same, which is