Excess liquidity and money market functioning autism
Thinking about the liquidity trap:. We live in the Age of the Central Banker - an era in which Greenspan, Duisenberg, and Hayami excess liquidity and money market functioning autism household words, in which monetary policy is generally believed to be so effective that it cannot safely be left in the hands of politicians who might use it to their advantage.
Through much of the world, quasi-independent central banks are now entrusted with the job of steering economies between the rocks of inflation and the whirlpool of deflation. Their judgement is often questioned, but their power is not. So far only Japan has actually found itself in liquidity-trap conditions, but if it has happened once it can happen again, and if it can happen here it presumably can happen elsewhere.
So even if Japan does eventually emerge from its slump, the question of how it became trapped and what to do about it remains a pressing one. In the spring of I made an effort to apply excess liquidity and money market functioning autism modern, intertemporal macroeconomic thinking to the issue of the liquidity trap.
The papers I have written since have been controversial, to say the least; and while they have helped stir debate within and outside Japan, have not at time of writing shifted actual policy. Moreover, too much of that debate has been confused, both about what the real issues are and about what I personally have been saying. The purpose of excess liquidity and money market functioning autism paper is twofold. First, it is a restatement of what I believe to be the essential logic of liquidity-trap economics, with an emphasis in particular on how the "modern" macro I initially used to approach the problem links up with more traditional and still very useful IS-LM-type thinking.
Consider the sort of economy introduced a few chapters into most undergraduate macroeconomics books: Since the classic paper by Hicks, it has excess liquidity and money market functioning autism usual to summarize short-run equilibrium in such an economy by looking at two curves: Monetary policy shifts LM, fiscal policy shifts IS.
Literally from the beginning of IS-LM analysis, however, Hicks realized that monetary policy might in principle be ineffective under "depression" conditions. The reason is that the nominal interest rate cannot be negative - otherwise, cash would dominate bonds as an asset. So at an interest rate near zero the demand for money must become more or less infinitely elastic, implying that the leftmost parts of the LM curve must actually be flat. Then changes in the money supply, which move LM back and forth, will have no effect on interest rates or output; monetary policy will be ineffective.
An alternative way to state this possibility is to say that if the interest rate is zero, bonds and money become in effect equivalent assets; so conventional monetary policy, in which money is swapped for bonds via an open-market operation, changes nothing.
I think that it is fair to say that for around two generations - from the point at which it became clear that the s were not about to reemerge, to the belated realization circa that Japan really was back in a 30s-type monetary environment - nobody thought much about the deeper logic of the liquidity trap.
But once it became clear that the Bank of Japan really did consider itself unable to increase demand in an economy that badly needed it, it also became clear to me at least that the theory of the liquidity trap needed a fresh, hard look. I started with a preconception: Partly this preconception represented wishful thinking: The IS-LM framework is, of course, an ad hoc approach that is excess liquidity and money market functioning autism careless about a number of issues, from price determination, to the consequences of capital accumulation, to the determinants of consumer behavior.
Rather, the apparent weakness of IS-LM was in its modeling of aggregate demand. In the IS-LM model both the money supply and the price level enter in only one place: Monetary policy and changes in the price level therefore affect aggregate demand through the same channel.
And to say that increases in M were ineffective beyond some point was therefore equivalent to saying that reductions in P were ineffective in raising demand - that the aggregate demand curve looked something like AD in Figure 2downward-sloping over some range but vertical thereafter. And in that case even full price flexibility might not be enough to restore full employment.
But as Pigou pointed out, that simply cannot be right. If the IS-LM model seems to suggest that no full employment equilibrium exists, it is only because that model does not really get the budget constraints right. And it seemed to me that what went for P must go for M; just as a sufficiently large fall in P would always expand the economy to full employment, so must a sufficiently large rise in M.
It seemed to me to be a truism that increases in M always raise the equilibrium price level, and hence given a downwardly inflexible price level will always increase output. So I set out to write down the simplest such model I could. And it ended up saying something quite different. Instead of the rather complicated world of the IS-LM model, imagine a pure exchange economy. There is a single consumption good, which drops as manna from heaven, so that consumption in each period is a given; the representative individual sets out to maximize a utility function of the form:.
In order to introduce money in a minimalist way, suppose that in order to purchase goods consumers must have cash in hand. Thus there is a cash-in-advance constraint each period of the form:. However, we simplify matters by assuming that additional cash may be acquired, or excess cash disposed of, in a money-for-bonds market that takes place at the beginning of each period.
As long as there is no uncertainty, this implies that under normal circumstances the cash-in-advance constraint 2 will be binding. It also implies an Euler condition on consumption, the nominal interest rate, and prices:.
Suppose that we consider a change in excess liquidity and money market functioning autism money supply only for the current period, via an open-market operation during that beginning-of-period asset market. The "IS" curve is defined by the Euler condition 3 ; the easiest way to think about it is to say that the real interest rate is given, so any rise in i must be offset by a fall in P relative to its future value, generating the expected inflation needed to keep the real rate constant.
The intersection of the two curves then simultaneously determines the interest rate and the price level. Unless, that is, the implied nominal interest rate is negative, as illustrated in Figure 3. What must happen in that case is that the cash-in-advance constraint ceases to be binding; in effect, some money is now held merely as a store of value, indistinguishable from bonds. And in that case any further increase in the money supply will have no effect; the economy will, in fact, be in the liquidity trap.
How should one think about this case? Perhaps the first thing to say is that the proposition of monetary neutrality, as usually stated, is not quite right. We normally say that if you double the money supply you double the equilibrium price level. The correct statement is that if you double the current and all expected future money supplies, you double the current price level; a monetary expansion perceived as temporary may have no effect at all. The reason is that the economy has a maximum rate of deflation, equal to the "natural" real rate of interest.
A temporary monetary expansion that tries to raise the current price level so high that it would have to be followed by deflation more rapid than this maximum rate will end up spilling over into excess, unused liquidity instead. Now you may ask, why would a central bank try to impose deflation? But there is nothing in the logic of this exercise that says that the maximum rate of excess liquidity and money market functioning autism must be positive.
If, for whatever reason, the natural real rate of interest is negative, then the economy "wants" inflation. You may well ask why and how it should happen that the natural real rate is negative; but just for the moment suppose that it is.
Then the economy will find itself in a liquidity trap as long as the private sector does not expect sufficiently rapid inflation.
It is important to notice that this does not mean that the old Keynesian idea that no full-employment equilibrium exists is validated. With fully flexible prices the economy will still manage to achieve full employment - but the mechanism is a bit unusual. Namely, the economy will get this inflationary expectations it needs via deflation - that is, by reducing the current price level compared with its expected future.
Now in excess liquidity and money market functioning autism macroeconomics it is possible to compensate for downward price inflexibility by increasing the money supply instead: But all is not lost for monetary policy. A credible commitment to expand not only the current but also future money supplies, which therefore raises expected future prices - or, equivalently, a credible commitment to future inflation - will still succeed in raising the equilibrium current price level and hence current output.
Let me say this perhaps more forcefully than I have in the past. Inflation targeting is not just a clever idea - a particular proposal that might work in fighting a liquidity trap. It is the theoretically "correct" response - that is, inflation targeting is the way to achieve in a sticky-price world the same result that would obtain if prices were perfectly flexible.
But it is inflation targeting that most nearly approaches the usual goal of modern stabilization policy, which is to provide adequate demand in a clean, unobtrusive excess liquidity and money market functioning autism that does not distort the allocation of resources. So the intertemporal approach led me to a different destination than I expected.
I thought it would show that the liquidity trap was not a real issue, that without the inconsistencies of the IS-LM model it would become clear that it could not really happen. Instead it turns out that a liquidity trap can indeed happen; but that it is excess liquidity and money market functioning autism a fundamental sense an expectational issue. Monetary expansion is irrelevant because the private sector does not expect excess liquidity and money market functioning autism to be sustained, because they believe that given a chance the central bank will revert excess liquidity and money market functioning autism type and stabilize prices.
And in order to make monetary policy effective, at least in a simple model, the central bank must overcome a credibility problem that is the inverse of our usual one. In a liquidity trap monetary policy does not work because the markets expect the bank to revert as soon as possible to the normal practice of stabilizing prices; to make it effective, the central bank must credibly promise to be irresponsible, to maintain its expansion after the recession is past.
For me, at least, the pure-exchange, manna and money model of the previous section was important as a mind-opener, as a way of laying bare the fundamental issues. But IS-LM remains in use for a reason: Now that we know that the IS-LM version of the liquidity trap is, properly interpreted, more or less right we can return to address some further complications - in particular, two non-monetary challenges to the excess liquidity and money market functioning autism idea of a liquidity trap.
The first challenge is embodied in the old rhetorical question, why not fill in the Gulf of Mexico? Or, in this case, the Sea of Japan — e. The point is that it is almost impossible to think of an economy in which there are literally no investment projects with a positive real rate of return; so how is it possible for the natural rate of interest to be negative? The second challenge is a more modern, subtle one: Of course the whole world could find itself in a liquidity trap assuming some answer is found to the first excess liquidity and money market functioning autismbut that is manifestly not the case excess liquidity and money market functioning autism present.
It turns out that for expositional purposes it is easier to address these questions in reverse order: So let us suppose that we have an economy with a negative "natural" real rate of interest. Figure 4 shows the savings and investment schedules at the full employment level of output.
If this were a closed economy this would mean that at full employment those schedules would cross below zero. Thus at a zero real interest rate there would be an incipient excess supply of savings, which would then translate via a multiplier process into a depressed real economy. So one might think that the economy can invest the excess savings abroad; the counterpart of that overseas investment would be a current account surplus, which would provide the additional demand the economy needs.
Indeed, analysts such as Smithers have argued that the essence of the Japanese dilemma is not the liquidity trap per se but the political problems raised by the implied trade surplus. However, it is not quite that simple.
While economists sometimes fall into the trap of supposing that savings-investment gaps are automatically translated into trade surpluses without any need for micro-level incentives to excess liquidity and money market functioning autism or buy more - a view John Williamson once referred to as the "doctrine of immaculate transfer" - in reality something has to effect the changes in exports and imports.
If we restrict ourselves to considering incipient gaps at full employment, the adjusting must be done via relative prices, which for simplicity we can summarize by the real exchange rate. Thus, ignoring some basically unimportant complications, we can write net exports as a function of the real exchange rate:. But what determines the real exchange rate? We could do this carefully and correctly, but the basic insight comes through via an ad hoc approach.
Investors will be aware that a country cannot run current account surpluses forever; in many empirical models it is assumed that they have in mind some long-run equilibrium real exchange rate, perhaps the rate at which net exports would be zero, and expect the actual rate to regress toward excess liquidity and money market functioning autism rate over time:.
The crucial point, then, is that given this expected change in the real exchange rate even risk-neutral investors will not equate real interest rates across countries; rather, arbitrage will set the expected depreciation of a currency equal to the real interest differential vis-as-vis the rest of the world:.
And this will therefore make both the real exchange rate and the level of net exports functions of the real interest rate:.
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