Recent developments in the Japanese economy are characterized by the concurrence of two rare phenomena: deflation and zero nominal interest rates. The year-on-year CPI inflation rate has been below zero for about six years since the second quarter of 1998 (see Figure 1). On the other hand, the uncollateralized overnight call rate has been practically zero since the Bank of Japan (BOJ) policy board made a decision on February 12, 1999 to lower it to be “as low as possible” (see Figure 2).

The concurrence of these two phenomena has revived the interest of researchers in what Keynes (1936) called a liquidity trap, and various studies have recently investigated this issue. These studies share the following two features. First, regarding diagnosis, they argue that the natural rate of interest, which is defined as the equilibrium real interest rate, is below zero in Japan, while the real overnight call rate is above zero because of deflationary expectations, and that such an interest rate gap leads to weak aggregate demand. This diagnosis was first made by Krugman (1998) and shared by Woodford (1999), Reifschneider and Williams (2000), Jung et al. (2003), and Eggertsson and Woodford (2003a, b) among others.