Search Results

The chapter focuses sharply on liquid assets, and is the heart of the book. It distinguishes between intrinsic and extrinsic liquidity, centering on the latter. Extrinsic liquidity may break down on the spur of the moment and generate socially costly Liquidity Crunch. A substantive part of the chapter is devoted to discussing relative resilience of liquid assets, and focuses on Keynes's Price Theory of Money, the resilience of the US dollar, the weakness of bonds denominated in that currency, and of currencies of emerging-market economies. The chapter claims that recent financial crises can realistically be modeled as old-fashioned bank runs, and that assets' liquidity may be a function of policy. Special attention is paid to a phenomenon called Liquidity Deflation, which helps to rationalize Liquidity Trap as a consequence of loss of money liquidity rather than on the conventional explanation based on the infinite interest elasticity of money demand.

The chapter presents a credit-friction New Keynesian model with heterogeneous agents, where patient agents lend and impatient agents borrow subject to a collateral constraint. If, for some reason, the collateral requirement becomes tighter, impatient agents will have to go into a process of de-leveraging, reducing the aggregate demand. This excess saving leads to a reduction in the natural interest rate that might become negative, and the nominal (policy) interest rate hits the zero bound, putting the economy into a liquidity trap. Then, traditional monetary policy becomes impossible, but fiscal policy regains some potency

The chapter shows that a sudden and sufficiently large contraction of bonds' liquidity could generate a fall in output, liquidity trap and price deflation, suggesting that there is no contradiction between Liquidity Crunch and Liquidity Trap, in line with the discussion in Chapter 2. The discussion is based on a simple model in which there are two types of liquid assets: fiat money and liquid bonds (e.g., Asset-Backed securities) under flexible prices. Fiat money is the liquid asset of choice for households, while under normal conditions firms have a preference for bonds. The model is employed to discuss quantitative easing (QE) in exchange for 'toxic' assets, and to show that the loss of bond liquidity could give rise to secular stagnation.

This chapter addresses the instruments and strategies for monetary policy. It concentrates on an uncommon target for the monetary authorities, namely the term structure of interest rates. The zero short-term interest rate does not necessarily mean the advent of the liquidity trap. It is shown theoretically and empirically that the impulse-response functions of the yield rates with respect to money shocks determine the shape of the term-structure of interest rates. Impulse-response functions of various yield rates with respect to monetary shocks as well as to the short-term interest rate reveal that the reactions of the yield rates may vary across the bonds with different maturities in terms of directions as well as in terms of magnitudes. For both the monthly and the quarterly, data sets exhibit that the interest rates of various maturities are significantly affected by M1 growth rate and its higher-order differences up to the third order.

This chapter applies Keynes’s principle of effective demand to re-interpret the analysis of Japan’s lost decade(s) by Krugman, McKinnon, and Koo. The analyses by Krugman, McKinnon, and Koo are shown to be special or restricted cases of Keynes’s general theory. Faced with a negative structural marginal efficiency of capital due to international forces, domestic fiscal policy loses its effectiveness. Contra Krugman, Japan cannot then inflate its way out of the liquidity trap; contra McKinnon Japan cannot restore growth by pegging to the US dollar; contra Koo a balance sheet recession is not the cause of Japan’s slower growth. The causes of Japan’s slower growth are international factors that depressed the domestic marginal efficiency of capital in the post-bubble period. Predominant among these factors was the rise of China and the rest of Asia.

The chapter surveys major financial crises that took place in the 1990s and early 2000s: (a) the credit implosion leading to a severe banking crisis in Japan and a long lasting liquidity trap; (b) the meltdown of foreign reserves triggered by foreign hot-money flight from the frothy economies of developing Asian nations with fixed exchange rate regimes economies.

This chapter argues that it is useful to divide the cyclical behavior of modern mixed capitalist economies into four phases: expansion, upper turning period, recession, and lower turning period. This characterization of the business cycle is more demanding and potentially more beneficial than the one currently used by the National Bureau of Economic Research, which identifies only the peak and trough of the cycle. To illustrate the value of this approach, this chapter examines the recent global financial crisis by reviewing the expansion driven by the development of the housing bubble. Then, the beginning of the crisis is regarded as the upper turning period. The initial financial instability evolved into a full crisis during the Great Recession due to its impact on unemployment. Finally, the ending of the crisis during the challenging period of the liquidity trap is analyzed as the lower turning period.

This chapter employs both theoretical and empirical tools to examine Japanese macroeconomic stabilization over the past five years. The role of fiscal policy in a liquidity trap is reviewed. It is shown that market participants expected that the Bank of Japan (BOJ) would not adopt expansionary monetary policy sufficient to offset an expected decline in the natural rate of interest. The Japanese government has been diverging from Ricardian fiscal policy since the latter half of the 1990s. The optimal commitment solution can be enforced through history-dependent inflation targeting in which the target inflation rate is revised depending on the past performance of monetary policy. The commitment of BOJ failed to have a sufficient impact on the market's expectations about the future course of monetary policy. Moreover, it is noted that the primary surplus in 1999–2002 was higher than predicted by the historical regularity.

This chapter presents a couple of “Keynesian” theories of the impact of redistribution, which claim that marginal tax rates have no effect on work hours during a recession, and that work hours are stimulated by any policy that puts resources in the hands of the poor and unemployed. The chapter explains how the fundamental differences between Keynesian approaches and mine are a matter of testable assumptions, and concludes with a simple econometric framework that embeds all of them. The relevant parts of that econometric model are estimated in the next chapter.

Chapter 4 considers economies with borrowing constraints. This assumption is motivated by the observation that monetary expansions after the Great Recession did not entail inflation in the expected manner. At the same time, nominal and real interest rates tended to decline in many advanced economies. The text offers an in-depth analysis of credit crunches, liquidity traps, and interest rates at the zero lower bound and demonstrates that borrowing constraints help reconcile theory and evidence. According to the key insight, a binding borrowing constraint detaches money creation from credit creation. In this case, inflation ceases to be a monetary phenomenon, as in standard models, but becomes a credit phenomenon. This finding explains why expansionary monetary policies failed to produce inflation since the Great Recession.

Although vital, the dollar standard's rehabilitation does not require international monetary reform. Rather, it is largely conceptual, and can be phased in through collaboration within just the G-2. China, a creditor country with a net saving (trade) surplus, can’t eliminate it by appreciation. Instead, both countries should phase out the saving (trade) imbalance by (1) increasing personal disposable income and hence consumption in China, and (2) raising net saving by eliminating the fiscal deficit in the United States. The trade imbalance would then take care of itself. The Federal Reserve Bank should commit to raising short-term interest rates toward 2 percent in the near future while leaving long rates to fluctuate “normally.” China should phase out its sterilization of hot money inflows as U.S. interest rates increase, and keep the yuan/dollar rate stable while continuing with its countercyclical credit policies. Once the G-2 succeed in harmonizing their financial policies, other countries can adjust their exchange rates as they see fit.