To make things worse, the Japanese economy is now stalling because of the banking crisis, thereby exacerbating economic woes, and creating a possible ever-worsening deflationary spiral. To have a sense of this problem, consider that last year the Bank of Japan increased money supply by 50% while, in an apparent contradiction, consumer prices continued to decline. This deflation reflects the failure of the bank multiplication effect--the mechanism by which a country's banking system multiplies liquidity in an economy through a chain of deposits reinvestment. Additional injected liquidity cannot keep pace with the contraction of banking loans. This classic "liquidity trap," a phenomenon first identified by John Maynard Keynes during the Great Depression, is caused by the dwindling confidence of depositors switching to cash as well as the banking system's own inability to extend new loans given the extent of needed write-offs.The liqudity trap argument was commonly found in textbooks of the 1950s, but by the late 1960s the argument had been sufficiently discredited that modern texts started dropping the notion as nonsense. It was discredited because, it was argued, there is no magic interest rate around which wealth holders develop expectations that rates can not go below. But in fact there is such a 'magic' number, viz., zero -- the pecuniary yield on hand-to-hand currency.
WSJ Interactive Edition 9/4/98
Jean Michel Paul and Robert Edelstein
The objective is to make sure that the rest of the world does not find itself in the position currently occupied by Japan. During a deflationary period the demand for currency rises (as its real yield, the negative of the inflation rate, rises) and the problem, as Keynes (General Theory Chapter 17) so brilliantly pointed out, is that a higher value of money fails to choke off money demand -- the own rate on money is invariant to the value of money.