The Case for Open-Market Purchases in a Liquidity Trap
By ALAN J. AUERBACH AND MAURICE OBSTFELD
Prevalent thinking about liquidity traps suggests that the perfect substitutability of money and bonds at a zero short-term nominal interest rate renders open-market operations ineffective for achieving macroeconomic stabilization goals. We show that even were this the case, there remains a powerful argument for large-scale open market operations as a fiscal policy tool. As we also demonstrate, however, this same reasoning implies that open-market operations will be beneficial for stabilization as well, even when the economy is expected to remain mired in a liquidity trap for some time. Thus, the microeconomic fiscal benefits of open-market operations in a liquidity trap go hand in hand with standard macroeconomic objectives. Motivated by Japan's recent economic experience, we use a dynamic general-equilibrium model to assess the welfare impact of open-market operations for an economy in Japan 's predicament. We argue Japan can achieve a substantial welfare improvement through large open-market purchases of domestic government debt. (JEL E43, E52, E63)
Japan's efforts to stimulate its economy over the past decade have led to apparent macroeconomic policy paralysis, with short-term nominal interest rates at their floor of zero and fiscal expansion immobilized by fears of augmenting an already-huge public debt.
Were short nominal interest rates positive, unanticipated open-market purchases of government debt would have the dual benefits of offsetting deflation and reducing the real value of yen-denominated public obligations. Prevalent thinking about liquidity traps, however, suggests that the perfect substitutability of money and bonds at a zero short-term nominal interest rate renders open-market operations ineffective as a stabilization tool.
Even in this circumstance, there remains a powerful argument for large-scale open market operations as a fiscal policy tool. To the extent that long-term interest rates are positive now or shortterm interest rates are expected to be positive at some point in the future, trading money for interest-bearing public debt reduces future debt-service requirements and hence the distortions of the requisite taxes. Thus, particularly for an economy in Japan's weakening fiscal position, large-scale open-market operations are an attractive policy, even if these operations are perceived to be totally ineffective at influencing current prices or output.
Yet, our analysis shows that this same reasoning implies that credibly permanent openmarket operations will be beneficial as a stabilization tool as well, even when the economy is expected to remain mired in a liquidity trap for some time. That is, under the same conditions on interest rates that make openmarket operations attractive for fiscal purposes, a monetary expansion that markets perceive to be permanent will affect prices and, in the absence of fully flexible prices, output as well. Thus, the microeconomic fiscal benefits of open-market operations in a liquidity trap go hand in hand with standard macroeconomic objectives.2
Our analysis shows that beneficial macroeconomic policies need not accelerate an economy's escape from a liquidity trap. Indeed, zero nominal interest rates per se need not be a problem for policy. Problems can stem, however, from the shocks that drive nominal interest rates to zero, and it is those shocks to which policymakers may wish to respond.
In this paper we use a dynamic generalequilibrium model to assess the welfare impact of open-market operations for an economy in Japan's predicament. We argue that a country like Japan can achieve a substantial welfare improvement through large open-market purchases of debt. The Bank of Japan has indeed been carrying out such operations since March 2001 through its policy of "quantitative easing." Our analysis suggests that Japanese policymakers should underscore the permanence of past operations, perhaps through an announced inflation target range including positive rates, and may need to increase the monetary base even more.3
In a flexible-price model with monopolistic competition and distorting taxes, we show that even though Japan currently has zero short-term interest rates, an open-market purchase can counteract deflationary price tendencies. In this setting with flexible prices, the policy will improve welfare by reducing the real value of public debt and hence the excess burden of future taxes. Two preconditions must hold for these effects to be possible. First, long-term nominal interest rates must be positive at some horizon (a condition that does hold in Japan today). Second, the central bank must be able to carry out credibly permanent increases in the level (not necessarily the growth rate) of the money supply, increases that can, but need not, be effected immediately. In Paul R. Krugman's (1998) account, monetary policy is powerless precisely because of an assumption that the central bank cannot commit itself not to reverse one-off increases in the money supply. Future expected money supply levels are constant because the central bank is assumed unwilling to tolerate any permanent rise in the price level.4 We argue that the credibility problem Krugman assumes is implausible as a total brake on policy effectiveness.
We also analyze a model with staggered nominal price setting in which anticipated deflation has negative welfare effects. In this setting, too, an unanticipated open-market purchase is expansionary. While the open-market purchase again has the advantage of devaluing government debt, it has an additional positive welfare effect by causing a Keynesian temporary output increase. There are further welfare impacts, moreover, due to the effects of unexpected and expected inflation on relative price dispersion, but these are unlikely to offset the primary gains.
The final goal of the paper is to simulate numerically the benefits of open-market expansion. We find that, for an economy with Japan's tax rates and public debt to GDP ratio, openmarket purchases of government debt yield large welfare benefits. Sizable benefits can be reaped, as we have noted, even when the accompanying inflationary impact is small.
I. The Term Structure of Interest Rates in Japan
A key assumption in the model we develop below is that short-term nominal interest rates, despite being zero today, are expected to be positive at some date (and in some state of nature) in the future. In other words, market participants see at least some chance that the economy will eventually escape from the liquidity trap. This assumption does not seem overly strong; on the contrary, the assumption of a fully permanent liquidity trap is, on its face, quite implausible. We nonetheless offer a more formal argument, based on the current term structure of interest rates in Japan, to show that our assumption about nominal interest-rate expectations is satisfied for that economy.
Figure 1 shows the evolution of Japan's term structure of interest rates since 1997. Short-term nominal rates are effectively at zero (very slightly positive, but just by enough to cover transaction costs). On the other hand, further out in the term structure-at maturities greater than a year--yields to maturity are higher, with that on the 20-year government bond still around 1 percent per annum.
A simple expectations theory of the term structure would, of course, imply some market expectation of positive future short-term interest rates: otherwise, the entire term structure would be flat at zero rather than upwardly sloped. The expectations theory, however, is highly questionable both on theoretical and empirical grounds. Fortunately we do not need to rely on it. There are other reasons for concluding that the term structure in Figure 1 is inconsistent with the hypothesis of a permanent (with probability 1) liquidity trap. None of the standard explanations for an upward-sloping term structure is plausible in the absence of positive expected future short-term nominal interest rates.
Consider first the possibility of conventional risk premia due to investor risk aversion. A major source of uncertainty in bonds' returns, however, is the future behavior of short-term interest rates. If those rates are at zero, they cannot fall. If investors simultaneously cannot envision an eventuality in which short-term rates might rise, then investors no longer consider short-term rates to be random at all. Under that circumstance, it would be impossible to generate risk premia that might justify the term differentials shown in Figure 1. The relative price of present and all future money payments is fixed at unity, so that money is a perfect substitute for bonds of any maturity.
Since the yields in Figure 1 are government bond yields, what about the possibility of government default as an explanation for relatively high long-term interest rates? That possibility might seem especially compelling in view of Japan's current high debt-GDP ratio, the likely fiscal costs of financial-sector restructuring, and the alarming forecasts for budgetary developments down the road as the population ages.6 A moment's reflection shows that this is not a plausible explanation for positive long-term rates in a world where short-term rates will never rise above zero. The reason is that, in the latter world, the government can trivially finance all its obligations by printing money. Money creation of such a magnitude could eventually ignite inflation, of course; but in that case, the hypothesis of short-term nominal interest rates frozen forever at zero would be contradicted.
Finally, consider liquidity effects. With short-term nominal interest rates pegged at zero, marketable debt instruments of different maturities all become equivalent to money, as we have noted. So again, one cannot rationalize term premia of the sort shown in Figure 1 purely as a liquidity effect.
We conclude that the only plausible explanation for the term structure shown in Figure 1 is that investors attach some positive probability to Japan's some day having positive nominal short-term interest rates. That circumstance, as we now show, is enough to give monetary policy considerable power to enhance economic welfare.
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