One of the nightmares of central bankers is the liquidity trap. This occurs when nominal interest rates approach or even equal zero. Once the interest rate has declined to zero, monetary expansion is ineffective because interest rates on securities cannot go below zero.
a. Explain why the nominal interest rate on government bonds cannot be negative. (Hint: What is the nominal interest rate on currency? Why would you hold a bond whose interest rate is below the interest rate on currency?)
b. A liquidity trap is particularly serious when a country simultaneously experiences falling prices, also called deflation. For example, in the early 2000s, consumer prices in Japan were falling at 2 percent per year. What were Japanese real interest rates during this period if the nominal interest rate was O?
What was the west real interest rate that the Bank of Japan could have produced during this period?