Monetary policy in a liquidity trap for an open economy

Transcription

1 Eco 553, Part 2, Spring o4.tex Lars Svensson 4/7/02 Monetary policy in a liquidity trap for an open economy The zero bound (floor), i t 0 Liquidity trap, real balances in excess of satiation level Satiation level m(c), P E t s=t U(C s,m s ) U C (C, m) > 0, U CC (C, m) < 0 ½ > 0 for m< m(c) U m (C, m) =0 for m m(c) ½ < 0 for m< m(c) U mm (C, m) =0 for m> m(c) U(C, m) =U(C, m) for m m(c) m(c) min m {m 0 U m (C, m) =0} U Cm (C, m) =0for m> m(c) 0 Copyright 2002 by Lars E.O. Svensson. This document may be reproduced for educational and research purposes, as long as the copies contain this notice and are retained for personal use or distributed free. 1 Money demand i t > 0: U m(c,m) U C (C,m) = i t =0: m m(c) Private sector budget constraint i t > 0, m t < m(c t ): i 1+i, m = g(c, i), lim i 0 g(c, i) = m(c) P t C t + M t i t B t + P t 1 1+r t b t = P t Y t P t T t + M t 1 + B t 1 + P t b t 1 i t =0, m t m(c t ): P t C t +(M t + B t )+P t 1 1+r t b t = P t Y t P t T t +(M t 1 + B t 1 )+P t b t 1 Nominal bonds and money perfect substitutes when i t =0, m t m(c t ) 2

2 Binding zero bound: Suppose i t =0.Thenr t = i t π t+1 t = π t+1 t. Suppose optimal monetary policy requires a lower r t (for instance, because of r t low, other shocks) Liquidity trap: Increasing M t (by open-market operations, reducing B t ) has no real or nominal effect Deflationary spiral Simple backward-looking PF model = π t + αx t x t = σ(i t π t+1 r t ) X L t = E t δ τ 1 2 (π2 t + λx 2 t) π t+1 Suppose π t = π t+1 t = x t = r t = i t =0for t<0 Suppose surprise, r t = ε<0 for 0 t T Without zero bound, optimal response i t = r t = ε, π t = π t+1 t = x t =0for τ 0 With zero bound, i t =0, 0 >x 1 = σε > x 2 >x 3 >..., 0 >π 2 = ασε > π 3... Buiter and Panigirtzoglou 99 τ=0 3 How to lower r t when i t =0 Increase π t+1 t Flexible prices Given p t+1 t, p t,fullemployment,π t+1 t = p t+1 t p t Sticky prices, p t sticky, unemployment Krugman (Posen): p t+1 t, announce positive inflation target, π > 0 (Krugman: 4%/yr for 15 years; Posen: 3%/yr first, 2%/yr after a few years) In future (t +1), out of liquidity trap, P t+1 M t+1 Promise high money growth ( to be irresponsible ), high M t+1 t, P t+1 t /P t, π t+1 t Problem: Why credible? CB renege? Why private sector believe? 4

3 4. How to handle the zero bound? How to avoid falling into a liquidity trap? How to escape from a liquidity trap? Fiscal policy (Ricardian equivalence?) Positive inflation target, credibility (Sweden) (Orphanides and Wieland, Krugman) Alternative instruments/intermediate targets Expanding the monetary base ( quantitative easing ) (Meltzer) Exchange-rate depreciation through FX interventions (buying foreign TBs) (McCallum, Bernanke 00) McKinnon: Permanent bilateral peg Reduce long bond rates by buying long government bonds Increasing asset prices by buying stocks and/or property Achieve negative interest rate by taxing money (Gesell 1949, Buiter and Panigirtzoglou 99, Goodfriend 00) The foolproof way (Svensson) Price-level target path (undo price-gap, get to positive inflation rate, avoid run-away inflation) Devaluation, temporary exchange-rate peg to jump-start economy (feasible to defend strong currency at low value) 5 The Foolproof Way of Escaping from a Liquidity Trap: Intro The zero bound, liquidity traps, Japan The foolproof way Price-level target path Depreciation and temporary exchange-rate peg Alternative proposals Is it really foolproof? Technical problems Political problems (Japan) 6

4 The zero bound, liquidity traps and Japan The zero bound, i t 0 Desired reduction in interest rate prevented Liquidity trap, i t =0 Liquidity saturation Money and TBs (close to) perfect substitutes Japan (Bernanke, Krugman, Posen) m t m t A lost decade Continued stagnation, deflation Zero interest rate, deflation, negative real interest rate, recession, output < potential output, high unemployment, expansionary fiscal policy, big budget deficit, high public debt Objective for macro policy: Escape from liquidity trap and recession, jump-start economy, get to small positive inflation rate, eliminate output gap and unemployment gap Objective for micro policy: Reforms, financial-sector clean-up (easier when out of recession). 7 The foolproof way of escaping from a liquidity trap 1. Price-level target path Best nominal anchor Undo price gap Provides exit strategy 2. Depreciation and temporary exchange-rate peg Jump-start economy: Increase output, price-level Real depreciation Lower real interest rate Induce inflation expectations 8

5 More specifically: 1. Announce an upward-sloping price-level target path {ˆp t } t=t 0 for the (log) domestic price level. ˆp t =ˆp t0 +ˆπ(t t 0 ), t t 0 (1) Current price-level target exceeds current price level ( price gap to undo) ˆp t0 >p t0 (2) Small positive long-run inflation target (1 2%/yr) ˆπ >0 9 2a. Announce devaluation and temporary peg Exchange-rate target (crawling peg, constant peg if ˆπ π ) s t = s t, t t 0 (3) s t s t0 +(ˆπ π )(t t 0 ), t t 0 (4) Choose initial devaluation to achieve initial real depreciation relative to steady state Real exchange rate q t p t + s t p t qt0 p t 0 + s t0 p t0 >q (5) 10

6 2b. Announce that, when price-level target path has been reached, the peg will be abandoned, in favor of flexible price-level targeting (FPT) with loss function (x t y t y t output gap) or flexible inflation-targeting (FIT) X E t τ=0 δ τ L t+τ L t = 1 2 [(p t ˆp t ) 2 + λx 2 t] (6) L t = 1 2 [(π t ˆπ) 2 + λx 2 t] (7) Then, just do it. 12

7 Transmission mechanism in open economy (Svensson 00b) Aggregate supply (Phillips curve) Inflation expectations Output gap Domestic inflation Real exchange rate Aggregate demand ¾ Long real interest rate Output gap Real exchange rate Expectations hypothesis Expected future short nominal interest rates Expected future inflation Real uncovered interest parity ¾ Long real rate 13 Why would this work? Devaluation and peg technically feasible Excess demand for domestic currency Once peg demonstrated, it will be credible s t+1 t = s t+1 Uncovered interest-rate parity Nominal interest rate increases i t = i t + s t+1 t s t + ϕ t (8) Already escaped from liquidity trap Tighter monetary policy? i t = i t +ˆπ π + ϕ t > 0 14

8 Details on establishing the peg 1. Before the peg, t t 0 i t0 =0 s t0 +1 t 0 s t0 = i t0 i t 0 ϕ t0 = i t 0 ϕ t0 < 0 (ϕ t relatively small) 2. Initial lack of credibility of the peg, t = t 0 s t0 = s t0 >s t0 s t0 +1 t 0 = s t0 +1 t 0 i t0 =0 s t0 +1 t 0 s t0 + i t 0 < ϕ t0 Expected (one-period domestic-currency) return on foreign bonds less than return on domestic bonds Excess demand for domestic currency CB sells domestic currency at rate s t0,gainsfxreserves Arbitrage ensures s t0 = s t Credible peg, zero interest rate i t0 =0 s t0 +1 t = s t0 +1 s t0 +1 t 0 s t0 + i t 0 =ˆπ π + i t 0 > ϕ t0 Expected (one-period domestic-currency) return on foreign bonds greater than return on domestic bonds Excess supply of domestic currency CB buys domestic currency at rate s t0, looses FX reserves 4. Credible peg, equilibrium interest rate i t0 + =ˆπ π + i t 0 + ϕ t0 > 0 FX market in equilibrium, no FX interventions Reduction in money demand/supply m t0 + p t0 = g(i t0 +,y t0 ) <m t0 p t0 Composition domestic credit/fx reserves subject to choice 16

9 Real UIP (examine real interest rate) (r t = i t π t+1 t, r t = i t π t+1 t ) Steady state Solve (9) forward r t = r t + q t+1 t q t + ϕ t (9) r = r + ϕ XT 1 XT 1 (r t+τ t r) = (rt+τ t XT 1 r )+q t+t t q t + (ϕ t+τ t ϕ) τ=0 q t+t t q (T ) ρ t τ=0 ρ t = ρ t + q q t + Φ t (10) X X (r t+τ t r) T (rt T r), Φ t = (ϕ t+τ t ϕ) τ=0 q t0 ρ t0 Real depreciation Reduction in long real interest rate τ=0 τ=0 17 Jump-starts economy Real depreciation Reduction in long real interest rate Increased aggregate demand and output 18

10 Inflation expectations Exchange rate-peg implies Initial real depreciation below steady state Expected (long-run) real appreciation (q t+1 q t ) [(p t+1 + s t+1 p t+1 ) (p t + s t p t )=(π t+1 ˆπ) (π t+1 π ) > 0 (Assume π t+1 π ) Expected real appreciation Expected inflation > ˆπ 19 Inflation > ˆπ Increased costs (real depreciation) Increased output (gap) Increased inflation expectations Inflation > ˆπ Real appreciation Price level approaches price-level target path from below When price-level target path reached, abandon exchange-rate peg for FPT or FIT 20

11 Role of price-level target and exchange rate peg Price-level target path Nominal anchor, benchmark Price gap to undo Exit strategy for exchange-rate peg Devaluation and temporary exchange-rate peg Technically feasible Provides benchmark Jump-starts economy: Increases output Creates inflation and inflation expectations 21 Comparison with other proposals Krugman, Posen: Announce inflation target, future monetary expansion Why credible? Price-level target path better anchor than inflation target Long-run inflation expectations independent of timing Price gap to undo Devaluation and exchange-rate peg demonstrates commitment Do, not just say Induces expectations of real appreciation and inflation 22

12 Meltzer, McCallum, Bernanke: FX interventions to depreciate currency Temporary peg more structure, benchmark Portfolio-balance effects (endogenous risk premia) McCallum reaction function s t = s t 1 + ν 0 ν 1 (π t,t 1 π ) ν 2 (x t,t 1 ) Time-varying exchange-rate target/instrument s t : Commitment to buy/sell unlimited amounts of FX at rate s t More complex commitment and benchmark, less verifiable Parameter values? Interest-rate setting? Exit strategy? 23 McKinnon, McKinnon-Ohno: Permanent bilateral peg $-=Y Would escape liquidity trap by i t = i t No real depreciation to jump-start economy No price gap to undo Sustainable? Optimal? Temporary peg, exit strategy Unilateral 24

13 Quantitative easing (Meltzer, Nakahara, current) Money and T-bills (close to) perfect substitutes Volumes, targets? Exit strategy? 25 Is it really foolproof? Technical problems Steady-state real exchange rate UIP, FX risk premia Sticky deflation Price-level target path credible? 26

14 Political problems (Japan) Reactions from BOJ (summer 2000) (Ueda 00) Since one cannot be absolutely sure, that any given policy action or change in the monetary policy regime will succeed in getting the economy out of the liquidity trap, it is safer not to try. Prudent policy: Try a number of suggested remedies (as long as not inconsistent), some may work Foolproof way might be useful if needed, but not needed now. Problems are over! DirectproposaltoMOFandUSTreasury. Myopic bureaucratic interests and technical details before national welfare Lack of Rooseveltian resolve (Bernanke) 27 BOJ and MOF cooperation MOF in charge of exchange-rate policy Shift burden from fiscal policy to monetary policy Beggar thy neighbor? Regional and US reactions? Easier 1 2 years ago Lower long-run real interest rate requires real depreciation Current-account effects of real depreciation ambiguous Region, U.S. and world gain in long run Other policy changes/reforms needed Financial-sector clean-up (Swedish way) 28

15 Summary There is a foolproof way It can help Japan (but is not enough alone) Any political problems can be solved Show Rooseveltian resolve The only thing we have to fear is fear itself... which paralyzes needed efforts to convert retreat into advance. 29