Monetary and Fiscal Remedies for Deflation

Transcription

1 Moneary and Fiscal Remedies for Deflaion Alan J. Auerbach and Maurice Obsfeld Universiy of California, Berkeley and NBER January 2004 This paper was presened a he 2004 Meeings of he American Economic Associaion. We hank Ben McCallum, our discussan, for commens.

2 Absrac Prevalen hinking abou liquidiy raps suggess ha he perfec subsiuabiliy of money and bonds a a zero shor-erm nominal ineres rae renders open-marke operaions ineffecive for achieving macroeconomic sabilizaion goals. In an earlier paper, we showed ha his reasoning does no hold, ha open-marke operaions can provide subsanial macroeconomic benefis and faciliae he use of powerful fiscal policy ools even in a liquidiy rap. In his paper, we consider an alernaive approach ha has been suggesed for use in a liquidiy rap, a scheduled increase in consumpion ax raes. We find ha such a policy could, indeed, increase shor-run consumpion, bu would be less effecive a increasing welfare or acceleraing a counry s exi from a liquidiy rap. Though a varian of his ax policy migh induce exi from a liquidiy rap, he impac of welfare is negaive in his case as well. We also argue ha his alernaive ax-raebased approach is subjec o more severe credibiliy problems han he moneary policy approach explored in our original paper. JEL Nos. E43, E52, E63 Alan J. Auerbach Maurice Obsfeld Deparmen of Economics Deparmen of Economics Universiy of California Universiy of California Berkeley, CA Berkeley, CA auerbach@econ.berkeley.edu obsfeld@econ.berkeley.edu

3 Japan s inabiliy o escape he quicksand of deflaion and salled growh has inspired numerous proposals for policy inervenion. A he same ime, Japan has provided he specacle of zero shor-erm nominal ineres raes, absen from world economic experience since he 930s. For cenral bankers and academic economiss alike, he apparen reurn of he Keynesian liquidiy rap inspires a mixure of fear and fascinaion. Adverse aggregaive performance is, unforunaely, far from being Japan s only curren economic problem. In addiion, he counry s financial insiuions are deeply roubled and is public finances seem o be on an unsusainable rajecory. The complex inerplay of hese problems has served o perpeuae policy inacion by he Japanese auhoriies. For example, he possible negaive effecs of higher ineres raes on banks and on he governmen s ineres bill are held up as reasons o avoid aggressive fiscal expansion. In earlier work, we showed ha moneary and fiscal expansion can inerac in a complemenary manner, leading o poenially large welfare gains, even for an economy in which he shor-erm nominal ineres rae currenly is zero (see Alan J. Auerbach and Maurice Obsfeld, 2003). Provided hey are viewed as permanen by he public, cenral-bank purchases of governmen deb wih money simulaneously raise prices, simulae oupu, and reduce governmen liabiliies ousanding, hereby allowing an immediae ax cu wih furher simulaing effecs. We analyzed qualiaive and quaniaive implicaions of his policy wihin a dynamic general-equilibrium model wih sicky prices and disoring axes. Some commenaors have expressed skepicism of moneary responses o acual or poenial deflaion, however. One concree alernaive, advanced by Marin Feldsein (2002), calls for enacing an increasing rae of value-added ax, accompanied by a gradual cu in he income ax ha renders he enire policy package revenue neural a each poin in ime. The

4 resuling ineremporal subsiuion effec, Feldsein argues, would resore posiive inflaion while simulaing consumpion spending in he shor run. Over he longer erm, he policy would faciliae a ransiion from an income ax o a consumpion ax, wih furher poenial gains in economic efficiency. Thus, he policy would arge boh shor-run simulus and long-run ax reform, wihou increasing fiscal deficis or running he risk of money-supply overshooing. In his paper we apply our dynamic equilibrium model o he Feldsein proposal, focusing in paricular on he effecs of an announced increase in he rae of consumpion axaion. There are wo main conclusions. Firs, an increasing pah of consumpion axes need no accelerae he economy s exi from a liquidiy rap. Second, even when ha exi is brough forward in ime, he policy is harmful o economic welfare. Skech of he Model 2 A represenaive household maximizes lifeime uiliy of consumpion (C ) and labor (L ), U = β U ( C, L ) = β 0U ( C0, L0 ) + β 0βU ( C, L ) + β 0β β U ( C, L ). 0 s = 0 s= 0 We impose he condiion ha he discoun facor β is less han in he long run bu allow i o vary exogenously in he shor run. Period uiliy akes he form U C L = γ (, ) C k L, () γ where γ is he ineremporal elasiciy of consumpion subsiuion. The parameer k formally measures he disuiliy of labor, bu /k is isomorphic in he model o he level of labor produciviy. There is perfec foresigh and he household faces a sandard ineremporal budge The simpliciy of our model does no allow us o disinguish he furher, long-run welfare effecs of a change in he ax base from income o consumpion; nor will we ouch upon some accompanying proposals by Feldsein ha cener on fiscal invesmen incenives. 2

5 consrain for ha case, wih i denoing he nominal ineres rae beween daes! and. Money demand is deermined by he cash-in-advance consrain M (+τ )P C, (2) where τ is he proporional consumpion ax (a key disorion in he model), P is he price level, and M is he (beginning-of-period) money supply. This consrain may no bind, of course, when i = 0. The governmen (consolidaed fiscal and moneary auhoriies) issues one-period nominal deb and finances is oulays hrough seigniorage and consumpion-ax proceeds. Governmen purchases are se a an exogenous level and heir impac on welfare is assumed separable. On he economy s producion side here are wo secors, each conaining a coninuum of monopolisic producers of differeniaed goods. The overall consumpion index C above is an equal-weighs Cobb-Douglas funcion of consumpion of he wo secors respecive producs, wih he secoral consumpion subindexes CES wih inraemporal subsiuion elasiciy ρ. Under sicky prices, he secors alernae in seing nominal produc prices ha are mainained for wo periods. This saggering disappears when prices are flexible. Oupu is linear in labor inpu (here is no capial in he model), so in he flexible-price case, price is a consan markup over he nominal wage w, P = ρw/(ρ ). The soluion for equilibrium consumpion is C = k ( + i w )( + τ ) P γ. (3) There are hree causes of deparure from Pareo opimaliy in he model, and expression (3) illusraes ha consumpion depends negaively on all hree of hem: he monopolisic markup 2 For a more deailed descripion of he model, see Auerbach and Obsfeld (2003). 3

6 P/w, he deparure from he opimum quaniy of money ineres rae of i = 0, and he posiive ax on consumpion, τ. A key requiremen for effecive moneary policy is he expecaion ha, a some poin in he fuure, he shor-erm nominal ineres rae will urn posiive. Suppose ha he nominal ineres rae is currenly zero, and le = T! be he dae upon which i firs happens ha i + > 0. (Our simulaions, described below, endogenize ha dae.) Using (2), (3), and he consumer s ineremporal Euler equaion, one can derive condiions linking he evoluion of nominal wages and prices: w k w k γ M T T T T = β s T s= + β ( P ( + τ )) γ γ = M β + ( P ( + τ )) γ, T, (4a), T. (4b) The implicaions of hese equaions are mos easily seen when γ = (logarihmic consumpion preferences) or when prices are flexible (so ha P is proporional o w ). In hose cases (and indeed, in general, even wih saggered prices and γ, alhough he analysis is more complicaed), only expecaions of he money supply on dae T maer for nominal wage and price deerminaion. This is he hallmark of he liquidiy rap. In a liquidiy rap, nominal prices fall a he real rae of ineres oward he erminal equilibrium price prevailing on he firs dae a which he demand for money is deermined in he normal fashion by liquidiy preference. Our previous analysis showed ha being in a liquidiy rap does no preclude he effecive use of moneary policy, if ha moneary policy akes he form of a change in he sock of money ha is susained hrough dae T. Moneary policy may also be used o spur a more rapid deparure from he liquidiy rap, bu his ransiion is no necessary for moneary policy o affec 4

7 curren oupu and prices. Announced, credible changes in he fuure money sock can simulae curren aggregae demand while a he same ime faciliaing reducions in disorionary axaion. Tha analysis assumed, for simpliciy, ha he rae of consumpion ax was held consan over ime for each paricular equilibrium pah, equal o he rae necessary o saisfy he governmen s ineremporal budge consrain. In he spiri of Feldsein s proposal, we now consider he impac of a shif from a consan ax rae pah o one wih raes ha are iniially low, in he iniial liquidiy-rap regime, and rise over ime o a consan, long-run level consisen wih ineremporal budge balance. Simulaion Approach We solve he model backward, following he echnique laid ou in more deail in Auerbach and Obsfeld (2003). Assume firs ha we know he sae of he economy a dae +, including wheher he economy is in a liquidiy rap. (This will urn ou no o be a resricive assumpion, if i is consisen wih he resuling equilibrium pah.) We may hen solve for he values of he wage rae, w, he price level, P, and he ineres rae, i, a dae, and hen proceed o dae -, and so on. This recursive procedure provides a soluion for he enire pah of he economy for given pahs of he policy variables M and τ. In order o ensure ha he governmen s ineremporal budge consrain is saisfied, we hen ierae, revising he values of τ wih each ieraion o mee he budge consrain. Once he ieraion process converges, he values of τ o which behavior responds are consisen wih he governmen s budge consrain, given ha behavior. Excep for assumpions abou he pah of τ and he value of he ineremporal consumpion elasiciy, γ, we adop he parameer values used in our earlier paper. In paricular, in order o generae an iniial equilibrium pah ha sars ou in a liquidiy rap, we assume ha he discoun facor, β, is iniially greaer han he pure rae of discoun is negaive, and his 5

8 paience on he par of consumers pushes down he equilibrium ineres rae. The value of β is assumed o fall afer 5 years, possibiliy reflecing changes in demography, risk preferences, or oher household aribues no explicily modeled. We also assume ha he produciviy parameer, k, falls over ime, his effecive rise in produciviy leading o growh in real money balances, as has occurred recenly in Japan. 3 Moneary and Fiscal Policy Simulaions Table presens resuls for four simulaions ha assume logarihmic uiliy and sicky prices. Each panel presens he rajecories of four key variables for a paricular simulaion he nominal ineres rae (i), he inflaion rae (π), aggregae consumpion (C), and he ax rae (τ, expressed on a ax-inclusive basis, i.e., as a share of gross-of-ax raher han ne-of-ax expendiures). The resuls are presened for six periods, beginning wih he period of he policy change and ending wih he period during which he economy exis from he liquidiy rap in he base case simulaion. Also shown for each simulaion (oher han he base case) is he welfare gain, measured as he policy s equivalen variaion increase in he presen value of lifeime resources relaive o he base case. In he base case, he nominal ineres rae is zero hrough period 5, afer which i rises o 4 percen. The inflaion rae is negaive while he economy is in he liquidiy rap, consumpion grows, and he ax rae, by assumpion, is consan. The panel in he able s upper lef shows he 3 The parameerizaion of our base case simulaion is as follows. We se he discoun facor β iniially a /0.97, falling o /.02 in period 5. We adjus he share of governmen purchases so ha he consan ax rae in he iniial equilibrium equals a recen esimae for governmen s share of oupu in Japan, 47 percen. We se he iniial raio of high-powered money o highpowered money plus governmen deb a 0.2. We assume ha he labor-disuiliy parameer, k, falls a an annual rae of 0.05, reaching.0 in period 5, when i ceases falling and remains consan hereafer. We se he inraemporal demand elasiciy, ρ effecively a compeiion parameer equal o 0, which induces a modes price-cos raio of 0/9. Finally, in he iniial equilibrium, we assume ha he money sock grows a a consan annual rae of 2 percen. 6

9 impac of an immediae and permanen 0-percen increase in he money sock. This policy increases inflaion for wo periods, spurs consumpion in he shor-run, due o he sluggish price response, and also increases consumpion in he long run, as a resul of he lower ax rae made feasible by lower real governmen deb. These increases in shor-run and long-run consumpion are associaed wih a 0.8 percen increase in welfare. Noe ha his policy increases welfare wihou disruping he liquidiy rap iself, illusraing ha i is he abiliy o conduc policy in a liquidiy rap ha is key, no he abiliy o eliminae he liquidiy rap iself. An alernaive moneary policy simulaion, shown in he lower lef, does deliver he economy immediaely from he liquidiy rap via an immediae increase in money growh. This policy, like he previous one, raises consumpion in he shor run, bu is long-run effecs and overall welfare gain are reduced by he very fac ha ineres raes are posiive, hereby increasing one of he hree consumpion disorions. The final panel in Table gives resuls for a simulaion in which he ax rae is se iniially a a low level and hen allowed o grow smoohly o is equilibrium level in period 5. As prediced, his spurs shor-run consumpion, much more han in any oher simulaion. Bu his increase in consumpion is only emporary. In he long run, he consumpion ax rae mus rise o pay for he emporary ax cu, leading consumpion o fall below is level in he base case. This long-run drop in consumpion more han ouweighs he shor-run increase. The inuiion for his resul comes from he ax-smoohing lieraure, which indicaes ha, all else equal, consumpion ax raes should be equal over ime o minimize ineremporal disorions. Varying consumpion ax raes is herefore welfare reducing. Indeed, because he shor-run drop in consumpion axes (unlike he previously considered money sock increase) simulaes demand wihou compressing price-cos margins, his poenial source of welfare gain is absen. 7

10 Ineresingly, his policy of ax-based demand simulus has no impac on nominal ineres raes or he duraion of he liquidiy rap. This is because he policy increases he demand for goods, bu no for money. Indeed, wih logarihmic uiliy and γ = (see expression 3), expendiure on goods, (+τ)pc, does no vary wih he full price of goods, (+τ)p. Hence, he demand for money, which equals expendiure, does no vary eiher, and here is no reducion in he excess supply of money. As Table 2 shows, his invariance resul breaks down when he ineremporal consumpion elasiciy, γ, is no equal o. 4 The able provides simulaions of ax rae growh policies ha successfully bring he economy ou of a liquidiy rap, for wo alernaive values of γ,.333 and 0.8. Bu noe ha, for γ < (empirically, he more likely case), his calls for ax raes o fall over ime. Given ha consumpion demand is inelasic, he demand for money acually declines wih a reducion in he ax rae, so a shor-run increase in money demand requires a ax rae ha is iniially higher. Noe, oo, ha, in boh policy experimens, he ax-rae variaion wheher rising or falling reduces welfare. As discussed above in he conex of moneary policy, escaping he liquidiy rap, in iself, should no be a fundamenal policy objecive, if saluary policies remain available in he presence of very low ineres raes. Tax rae variaion may succeed in eliminaing he liquidiy rap, bu he underlying policy jusificaion remains weak. A Furher Issue: Credibiliy We have demonsraed ha moneary policy can remain effecive in a liquidiy rap, and ha ax rae variaion, while also effecive a simulaing shor-run demand, lacks he welfare-enhancing properies of an immediae, credibly permanen moneary expansion. Bu credibiliy is a key requiremen for moneary policy effeciveness, so one migh ask wheher alernaive polices, 4 For simpliciy, he simulaions in his able assume flexible pricing. 8

11 such as he ax rae variaions considered above, are more aracive in his regard. In paricular, will i be easier for a governmen o mainain a commimen o raise ax raes over ime han o mainain an increase in he money supply? We would argue, o he conrary, ha he ax policy will be more difficul o mainain. The governmen would forgo seigniorage i has already capured by reversing an open marke operaion purchase of bonds; i has every incenive no o do so, even if he economy s response o is policy is delayed. On he oher hand, a governmen ha has promised o raise consumpion axes, if confroned by an iniial lack of economic response, may find i difficul o adhere o such a promise in he face of coninued weakness in consumpion demand. Thus, he moneary policy approach remains preferred. 9

12 References Auerbach, Alan J. and Maurice Obsfeld. The Case for Open-Marke Purchases in a Liquidiy Trap. Naional Bureau of Economic Research (Cambridge, MA) Working Paper No. 984, July Feldsein, Marin. Commenary: Is There a Role for Discreionary Fiscal Policy? in Rehinking Sabilizaion Policy. Kansas Ciy, MO: Federal Reserve Bank of Kansas Ciy, 2002, pp

13 Table The Impac of Moneary and Fiscal Policy (logarihmic uiliy and saggered price-seing) Simulaion: Base Case Increase Money Sock by 0% Period i π C τ i π C τ Welfare Gain Simulaion: Double Money Growh Rae Tax Rae Grows Period i π C τ i π C τ Welfare Gain Table 2 Using Consumpion Taxes o Escape he Liquidiy Trap (flexible price-seing) γ =.333: Base Case Time-Varying Tax Rae Period i π C τ i π C τ Welfare Gain γ = 0.8: Base Case Time-Varying Tax Rae Period i π C τ i π C τ Welfare Gain