Preliminary Centralbankbalancesheetsandtheliquiditytrap MichaelT.Kiley * March2003 Version2.1 *Address : WhileonLeave(September2001-August2003) —OECDEconomicsDepartmentCS1,2rue AndrePascal,75016ParisFRANCE. Email : [email protected] . PermanentAddress :MailStop67, FederalReserveBoard,Washington,DC20551. Email : [email protected] . Acknowledgements :Thisisasubstantiallyrevisedversionofanearlierpaper,“Escapingaliquiditytrap: Anold-fashionedanalysiswithanewtwist”.IwouldliketocolleaguesattheFederalReserveBoardand studentsatJohnsHopkinsUniversityinWashington,DCfordiscussionsthatprovidedthebaseforthis researchandDavidRomerforskepticalcommentsonanearlierdraft.Theviewsexpressedhereinare thoseoftheauthor,anddonotrepresentthoseoftheOECD,theFederalReserveBoard,ortheirrespective staffs. i Centralbankbalancesheetsandtheliquiditytrap Abstract Theeffectivenessofpolicyinaliquiditytrapisconsideredinasimplemodel.Themodel illustratestheinteractionbetweenfiscalandmonetarypolicy.Ithighlightshow traditionalpolicyresponses,suchasexpansionaryopen-marketoperationsorbond- financedtaxcuts,havenostimulativevalue,butnon-traditionalfiscal/monetaryactions, suchasmoney-financedtaxcutsornon-Ricardiantaxcuts,arestimulative.Thefiscal theoryofthepriceleveliscrucialinaliquiditytrap,asmoneylosesitsspecialcharacter oncethenominalinterestratehitszero.Finally,theanalysishighlightstworesultsof practicalrelevanceregardingcentralbanklossesandtheexchangerateeffectsofpolicies inaliquiditytrap.Withregardtotheformer,themodelillustratesthatanymonetary actionthatliftstheeconomyfromtheliquiditytrapmustinvolveadeteriorationofthe centralbank’sbalancesheet;hence,aninstitutionalframeworkthatforbidssuchlosses hindersanescapefromaliquiditytrap.Withregardtothelatter,monetaryactionsthat succeedinliftingtheeconomyfromaliquiditytrapgeneratearealcurrencyappreciation, reflectingthefiscalnatureofthemonetaryaction;hence,suchactionscannotbe criticizedon“beggar-thy-neighbor”grounds. JELCodes:E52,E31,B22 Keywords:LiquidityTrap,Deflation,FiscalandMonetaryPolicyInteraction,Fiscal TheoryofthePriceLevel ii 1. Introduction Previouslyrelegatedtothedustbinofhistory,theliquiditytrapisback–inmodernJapan andontheresearchagenda. 1Theappropriatepolicyresponsehasprovencontroversial. Suggestionsincludeaninflationtarget(Krugman(1998)),fiscalexpansion(Posen (1998)),aprice-leveltarget(Wolman(1998),Lilico(2002)),monetaryexpansion (Meltzer(1999)),ataxoncurrencyholdings(BuiterandPanigirtzoglou(1999)),currency depreciation(McCallum(1999),CoenenandWieland(2003)),andacombinationofa currencydepreciationandprice-leveltarget(Svensson(2001)).Mostoftheseproposals areatleastimplicitlydiscussedbelow,astheeffectsofdifferentmonetaryandfiscal actionsareexamined.Unfortunatelytheseproposalsmayhavelimitedeffectiveness,at leasttotheextentthatabaselinegeneralequilibriummodelwithmonetaryfrictions providesareasonableguideforpolicy. Themodeldevelopedhereinisatwo-period,deterministicopen-economymodel withanoptimizingrepresentativeconsumerandflexibleprices.Inthemodel, expectations(or,morepreciselygivenperfectforesight,futurevalues)areveryimportant (forconsumptiondecisions,assetprices,andhencefortheliquiditytrap).Theresults demonstratethatthemonetaryauthority,throughopen-marketoperations,cannot engineerinflation,price-leveltargetsorcurrencydepreciationoncetheeconomyenters theliquiditytrap.ThissuggeststhatSvensson’s(2001)foolproofpolicycannotliftthe economyfromaliquiditytrapwithoutfiscalorbalancesheeteffectsashasbeenclaimed (apointdevelopedmorebelow). 2Thisresultisstandardforthetypeofmodelanalyzed, buthighlightsthatsuggestionsforsuchpoliciesmusteitherinvolvemonetaryactions otherthansecuritypurchasesorimperfectionsnotincludedinthemodel,suchas imperfectsubstitutabilitybetweendifferentassetsthatgeneratesportfoliobalanceeffects. Suchimperfectionsmaynotallowforverypowerfuleffectsofmonetarypolicyina liquiditytrap. 3 1Krugman(1998)getscreditforthesnappyphrasingandanearlyreturntothetopic. 2SomereadersmayimmediatelyobjectbeforeturningtotheanalysisthatSvensson(2001)doesnotrelyon portfoliobalanceeffects.However,acarefulreadingofhisappendix2suggestsotherwise. 3Lebow(1993)presentsacogentdiscussionofthelimitedrole“non-traditional”monetarychannels,such asportfoliobalanceorcreditchannels,mayhaveinaliquiditytrap,evenifsuchchannelsarepowerful outsidealiquiditytrap. 1 Traditionalfiscalpolicymayalsoberelativelyimpotentforseveralreasons. First,whenfiscalpolicyispursuedinaRicardianfashion(asdefinedbyWoodford (2001)orCochrane(1998)),theaggregatedemandeffectsofdeficit-financedtaxcutsis nil(orverylimited)becauseofRicardianequivalence(Barro(1974)).Inaddition, governmentconsumptionandinvestmentmaybe(good)substitutesforprivatespending, implyingthatincreasesingovernmentspendingmayhavelittleeffectonaggregate demand(i.e.,asmallgovernmentspendingmultiplier(Krugman(1999))).Boththese reasonsmayexplainpartoftheapparentlyweakaggregatedemandeffectsoffiscal stimulusinJapaninthelate1990s(OECD(2000)).Anotherlimitoffiscalpolicymaybe theabilityofthefiscalauthoritytopursueexpansionarymeasuresgiventhelong-run fiscaloutlookandthefeasibilityofraisingfuturerevenuesorcuttingfutureexpenditures. Thisconcernmayhavebeenmoreimportantinlimitingthedegreeoffiscalexpansion pursuedbyJapanrecently(astheratioofgovernmentdebttoGDPexceeded120percent in2000andimplicitpublicpensionliabilitiesarelarge). Giventheimpotenceofsecuritiespurchasesorbond-financedtaxcutswhen facingaliquiditytrap,innovativemonetaryandfiscalpolicyactionsareexaminedinthe model.Monetaryactionstorelaxthegovernment’sbudgetconstraintornon-Ricardian fiscalpolicycanlifttheeconomyfromtheliquiditytrap.Theappealtothefiscaltheory ofthepriceleveliscrucial,asmoneylosesitsspecialcharacter(i.e.,anecessarybut dominatedassetclass)oncethenominalinterestratehitszero.Themonetaryandfiscal authoritiesmustcommittoinflatingaway(loosely,monetizing)someportionof outstandingnominalliabilities.Inessence,theeffectsofmonetaryactionsrepresent somepleasantmonetaristarithmetic–theboostingofinflationthroughthefiscaleffects ofmonetarypolicyemphasizedbySargentandWallace(1981).Itshouldbenotedthat relaxationofthegovernment’sbudgetconstraintthroughmonetaryexpansionisoften mentionedasapossibility(e.g.,Clouseetal(2000),andBernanke(2000)),buttypically isfrowneduponasinappropriate.Suchreasoningisdifficulttocomprehend,asmoney andbondsareperfectsubstitutesinaliquiditytrap;sinceconsumersarewillingto increasetheirholdingsofmoneyinaliquiditytrapandthegovernmentcanlowertax 2 burdensbyincreasingthesupplyofmoneywithoutresourcecosts,itwouldseem appropriateforthegovernmenttoissuemoremoneyandcuttaxes. 4 Twopracticalissuesarisefromtheanalysis.First,themonetaryactionssuggested havenegativeeffectsonthecentralbank’sbalancesheet,reflectingthemonetizationof governmentliabilities.Providingmoneytothetreasurywithoutanaccompanying increaseinassetsonthecentralbank’sbalancesheetimpliesthattheoutstandingstockof moneyexceedstheassetsheldbythecentralbank.Ofcourse,suchabalancesheet deteriorationisnoteconomicallyimportant;acentralbankcouldalwayssimplyprint moremoneywheneveranyonewishedtoexchangetheirmoneyforanasset(more money),withoutanychangeinthestockofmoneyheldbythepublic.However,such lossesarepreventedincertaininstitutionalsetups,mostnotablyinJapan,wheretheBank ofJapanisaprivateentitythatmustremainsolvent.Sinceonlymonetaryactionswith negativeconsequencesforthecentralbank’sbalancesheetallowanescapefromthe liquiditytrap,suchinstitutionalframeworkslimitthepotentialofmonetarypolicy. Inaddition,thetypeofmonetaryexpansiondescribedmayleadtoarealcurrency appreciationintheshortrun(ratherthantherealdepreciationpredictedbyportfolio balancechannels),reflectingthefiscalnatureofthemonetaryaction.Hence,suchpolicy actionscannotbecriticizedonthe“beggar-thy-neighbor”groundsofcallsforcurrency depreciation(e.g.,Stevens(2001),thediscussioninSvensson(2001)andCoenenand Wieland(2003)).Thistheoreticalpredictionhasnotbeenpreviouslydiscussed,and suggestsevenmorestronglythepotentialdesirabilityofthepolicyforJapanintheyears following2001,whenworldaggregatedemandappearstobefalteringandbeggar-thy- neighboractionsmayaggravateadversedevelopmentselsewhereinAsiaorintheUnited States( TheEconomist (2001)). 2.Asimpleeconomy Themodelisofasmall,openeconomy,consistingofarepresentativeconsumeranda government(whichcanbebrokendownintoacentralbankandtreasuryifsucha 4Outsideoftheliquiditytrap,increasesinthemoneysupplyboostthenominalinterestrate(byincreasing inflation)andhencecreatedistortions.However,suchdistortionsareabsentintheliquiditytrap,wherethe nominalinterestrateiszero. 3 breakdownisdesired).Theeconomyconsistsoftwoperiods,period1andperiod2. Domesticoutputisexogenous,andthepricelevelisperfectlyflexible.Hence,the liquiditytrapisasituationwherethemonetaryauthoritycannotinfluencethepricelevel throughopen-marketoperations,ratherthanasituationwherethemonetaryauthority cannotinfluenceoutput.AsinKrugman(1998),addingstickypricesanddemand- determinedoutputlevelswouldtransformtheliquiditytraptoasituationwherethe centralbank’sattemptstoinfluenceoutputarethwarted,therebyinjectingaKeynesian flavorintotheanalysis.However,suchamodificationaddsnoinsightandhenceis ignoredforsimplicity. 2.1Therepresentativeconsumer Therepresentativeconsumerspreferencesoverconsumptionofthedomestically producedgood(c(j),j=1or2)andtheforeigngood(g(j),j=1or2)aregivenby Eq.1 a ln[ c )]1( + 1( − a)ln[ g )]1( + D{a ln( c )2( + 1( − a)ln[ g )]2( ,} where“a”isaparameter(equaltotheexpenditureshareofdomesticgoodsintotal consumptionexpenditure)andDisthediscountrate.(Notethatinwhatfollows, variablesdenotedwithalower-caseletterrefertorealvariables,suchasconsumption,