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2021 | OriginalPaper | Buchkapitel

Long-Run Mild Deflation Under Fiscal Unsustainability in Contemporary Japan

verfasst von : Makoto Saito

Erschienen in: Strong Money Demand in Financing War and Peace

Verlag: Springer Singapore

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Abstract

Chapter “Public Bonds as Money Substitutes at Near-Zero Interest Rates: Disequilibrium Analysis of the Cur-Rent and Future Japanese Economy” presented a simple framework of disequilibrium analysis, in which strong money demand, induced by near-zero rates, helps to absorb excess supply in goods, labor, and public bond markets. However, the analysis is at most diagnostic without any theoretical rigor or quantitatively precise simulation. In this chapter presents a formal equilibrium model, in which public bond price bubbles are present temporarily or even persistently, but burst with a tiny probability per year. As discussed in Chapter “Public Bonds as Money Substitutes at Near-Zero Interest Rates: Disequilibrium Analysis of the Cur-Rent and Future Japanese Economy”, those bubbles and their bursting in equilibrium analysis are interpretable as excess money demand and its disappearance in disequilibrium analysis. One of the most important implications in this chapter is that the model can yield reasonable predictions concerning the price level and a wide range of public bond yields, not only for the period when the short-term rate was already near zero (from the mid-1990s), but also for the period when it was far above zero (from the mid-1980s to the mid-1990s). For the latter period, the model predicts that the price level switches from mildly inflationary to mildly deflationary, and that the short-term rate declines quickly, but that yield curves remain upward sloping. For the former period, on the other hand, yield curves were gradually flattening at near-zero rates. In terms of future implications, if the bubbles burst, then the price level and rate of interest would jump immediately. As discussed in Chapter “Public Bonds as Money Substitutes at Near-Zero Interest Rates: Disequilibrium Analysis of the Cur-Rent and Future Japanese Economy”, strong commitment to future fiscal reforms by a government would help a one-off price surge to stop at a level several times higher than before. Here, it is assumed that a rare but catastrophic event, such as a large-scale inland earthquake in Tokyo, causes the bubbles to burst, leading to sharp declines in real output in the following years. Given a strong aversion to catastrophic endowment shocks, the model is able to yield even more realistic predictions for the price paths and the shape of yield curves, both of which would prevail before the bubbles burst.

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Vorheriges Kapitel Public Bonds as Money Substitutes at Near-Zero Interest Rates: Disequilibrium Analysis of the Current and Future Japanese Economy

Nächstes Kapitel Central Bank Cryptocurrencies in a Competitive Equilibrium Environment: Can Strong Money Demand Survive in the Digital Age?

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Many papers, including Braun and Joines (2015) and Imrohoroglu et al. (2016, 2019), convincingly argue that fiscal sustainability in Japan is never achieved without any drastic tax increases or spending cuts. Armstrong and Okimoto (2016) survey the literature on fiscal sustainability in Japan.

On the monetary side, Krugman (1998), Eggertsson and Woodford (2003), and Jung et al. (2005), among others, recommend that a central bank strongly commit to a zero-interest rate policy not only before, but also after, an economy escapes from a liquidity trap. On the fiscal side, Sims (2016) proposes a fiscal stimulus to yield upward pressure on the price level, following the standard implications of the fiscal theory of the price level. Christiano et al. (2011) and Woodford (2011), among others, perceive a liquidity trap as a consequence of weak aggregate demand and demonstrate that the fiscal multiplier is much larger in a liquidity trap than during normal times. In the US context, Bianchi and Melosi (2017) demonstrate that the lack of deflation in the US economy at zero-interest rates can be explained by people believing, with some probability, that aggressive fiscal policies will continue even after an escape from a liquidity trap. As Blanchard (2019) emphasizes, debt rollovers may be feasible even in an economy with much public debt when interest rates continue to be below growth rates. Applying this implication, Blanchard and Tashiro (2019) recommend even more aggressive fiscal policies for the current Japanese economy.

In this chapter, a government’s intertemporal budget constraint is interchangeable with its life-time budget constraint.

Hagedorn (2018) regards public bonds as net wealth in the sense that the public bond valuation exceeds the present value of future fiscal surpluses, and presents a similar monetary model as in this chapter.

In the sense of Woodford (1995), a fiscal disturbance is neutralized in the case of Ricardian fiscal policies, but it is not in the case of non-Ricardian policies.

The consumption deflator is adopted because it captures a deflationary trend as a result of the nature of the Paasche index.

When a 3% consumption tax was introduced in April 1989, most of the existing indirect taxes were abolished. Thus, its introduction had little impact on the average price level. On the other hand, the overall price level increased by around 2% when the tax rate was raised to 5% in April 1997, and again by about 2% when the rate was hiked to 8% in April 2014. The private consumption deflator, reported throughout this chapter, is adjusted by the impact of these consumption tax hikes on the average price level.

Here, the narrowest category of money stocks is chosen.

According to Ito et al. (2011), Japanese fiscal policy began to lack discipline as early as 1970, and the debt–GDP ratio was nonstationary from then.

The BOJ attempted to flatten the yield curves for up to ten-year yields from September 2016 by carrying out quite generous limit orders for long-term JGBs.

As discussed in Chapters “Public Bonds as Money Substitutes at Near-Zero Interest Rates: Disequilibrium Analysis of the Cur-Rent and Future Japanese Economy and Central Bank Cryptocurrencies in a Competitive Equilibrium Environment: Can Strong Money Demand Survive in the Digital Age?”, the assumption that money demand never saturates at any finite level of real money stocks (\({v}^{{\prime}}\left(\frac{M}{P}\right)>0\) for a finite \(\frac{M}{P}\)) is crucial in the discussion in this chapter. On the other hand, if \({v}^{{\prime}}\left(\frac{M}{P}\right)\) reaches zero at the upper limit of \(\frac{M}{P}\) and money demand saturates, then strong money demand never emerges.

In Chapters “Public Bonds as Money Substitutes at Near-Zero Interest Rates: Disequilibrium Analysis of the Cur-Rent and Future Japanese Economy and Central Bank Cryptocurrencies in a Competitive Equilibrium Environment: Can Strong Money Demand Survive in the Digital Age?”, bond and money stocks are defined at the end of period.

The assumption of reimbursing seigniorage to households follows the tradition of the FTPL in the sense that the public bonds are redeemed only by real fiscal surpluses. In a related study, Sargent and Wallace (1981) include seigniorage in the government’s budget constraint in determining the price process.

Buiter and Sibert (2007) prove that Friedman’s rule is not available in standard monetary models, in which real money demand never saturates.

If a means of exchange alternative to central bank money is more readily available and \(\upchi\) is larger, then \(0<\uplambda {\chi }^{-\frac{1}{\sigma }}c<1\) is more likely to be satisfied with a lower upper limit on the inflation rate (\(\frac{{P}_{t+1}^{FS}}{{P}_{t}^{FS}}\)).

When \(d>0\), a disciplined fiscal policy (3.5) or (3.6) is assumed to be implemented at time \({s}^{{\prime}}>s+L,\) that is, only after the catastrophic shocks disappear completely.

The unfunded component, or the non-zero terminal condition, has the same structure as the rational bubble proposed by Blanchard and Watson (1982), Weil (1987), and others, in the sense that its real value grows at a discount rate (\(1-\upbeta\)) plus a bursting probability (\(\uppi\)).

If \(d\) (the size of the catastrophic damage per period) is small, but \(L\) (the length of the catastrophic period) is long, then the initial catastrophic shock is large.

If the initial price \({P}_{0}^{NR}\) is equal to \({P}_{0}^{QT(d=0)}\), then it is assumed that the price process follows the QTM without any catastrophic shocks.

Here, longer-term public bonds are redundant assets and can be replicated from the one-period public bonds. Thus, the yield curve is neutral with respect to the maturity structure of the public bonds. In this regard, our model differs from that of Cochrane (2001), where the maturity structure of the public debt has effects on current and future inflation.

A large-scale inland earthquake in Tokyo may be one of the most likely trigger events, because it might immediately cause interest hikes upon completely exhausting domestic private savings. As shown in the next footnote, its estimated economic damage (around 20% of nominal GDP) would be equivalent to about three years’ worth of private savings. As shown in Fig. 9 in Chapter “Introduction: Toward a Monetary and Fiscal Theory of the Price Level”, the annual private saving ranged from 7 to 8% of nominal GDP in the 2010s.

The Disaster Management Department (2013) does not estimate initial and subsequent effects on GDP, but predicts that direct and indirect losses would be 47.4 trillion yen (around 10% of nominal GDP at FY2012), and 47.9 trillion yen (around 10%), respectively. We assume that the initial impact on real GDP is approximated by the sum of the estimated direct and indirect losses (\(9.8\mathrm{\%}+9.9\mathrm{\%}\)).

Even in the FU regime, \(\frac{{M}_{t}}{{P}_{t}c}\) initially remains close to the level that holds in the FS regime.

Given the above set of parameters, \(\uplambda {\chi }^{-\frac{1}{\sigma }}c\) (\(=\uplambda\) in this case) is greater than one; it is 71.7 in Cases 1 and 2, 1.67 in Case 3, and 53.8 in Cases 4–7.

As implied by Eq. (3.25), the initial price level \({P}_{1980}^{NR}\) is independent of the initial balance of the public bonds \({B}_{1980}\).

As we assume a low value for \(\upsigma\), inequality (3.20) and \(0<\eta <1\) are satisfied in all cases. Concretely, \(\eta\) is computed as 0.8035 in Cases 1 and 2, 0.9069 in Case 3, and 0.8450 in Cases 4–6.

According to Okazaki and Sudo (2018), the natural rate of interest was 4% in the 1980s, but it decreased to 0.3% in the 2010s.

For the yield curve starting from 1981, we assume that endowment shocks are absent (\(\Delta =0\)) because we assume that catastrophic endowment shocks are present from 1986 onwards.

As implied by Eq. (23), the share of the unfunded component is independent of the initial value of the public bonds (\({B}_{1980}\)).

For example, Aiyagari and Gertler (1985) examine the intergenerational impacts on nominal variables in the context of overlapping generations models.

As discussed in detail in Chapter “Central Banknotes and Black Markets: The Case of the Japanese Economy During and Immediately After World War II”, GNE deflator, which was estimated for the wartime and postwar periods by the Economic Planning Agency (1964), reflected transactions involving not only official (authorized) prices, but also (black) market prices. Thus, this is not a case in which the level of nominal GNE was heavily underestimated as a result of employing only officially regulated prices for the estimation.

See Chapters “Introduction: Toward a Monetary and Fiscal Theory of the Price Level and Central Banknotes and Black Markets: The Case of the Japanese Economy During and Immediately After World War II”, for the data sources.

Given a set of parameters for Japan’s economy, \(\uplambda {\chi }^{-\frac{1}{\sigma }}c>1\) holds, and hyperinflationary equilibria are ruled out in both the FU and FS regimes.

Titel: Long-Run Mild Deflation Under Fiscal Unsustainability in Contemporary Japan
verfasst von: Makoto Saito
Verlag: Springer Singapore
Buch: Strong Money Demand in Financing War and Peace
Print ISBN: 978-981-16-2445-2

Electronic ISBN: 978-981-16-2446-9

Copyright-Jahr: 2021
DOI: https://doi.org/10.1007/978-981-16-2446-9_5