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Svensson「流動性の罠とデフレーションからの脱出;The Foolproof Way他」2003(後半)


Currency Depreciation


Even if the nominal interest rate is zero, a depreciation of the currency provides a powerful way to stimulate the economy out of the liquidity trap (for instance, Bernanke (2000); McCallum (2000); Meltzer (2001); Orphanides and Wieland (2000)). A currency depreciation will stimulate an economy directly by giving a boost to export and import-competing sectors. More importantly, as noted in Svensson (2001), a currency depreciation and a peg of the currency rate at a depreciated rate serves as a conspicuous commitment to a higher price level in the future, in line with the optimal way to escape from a liquidity trap discussed above. An exchange-rate peg can induce private-sector expectations of a higher future price level and create the desirable long-term inflation expectations that are a crucial element of the optimal way to escape from the liquidity trap.

In order to understand how manipulation of the exchange rate can affect expectations of the future price level, it is useful to first review the exchange-rate consequences of the optimal policy to escape from a liquidity trap outlined above. That policy involves a commitment to a higher future price level and consequently current expectations of a higher future price level. A higher future price level would imply a correspondingly higher future exchange rate (when the exchange rate is measured as units of domestic currency per unit foreign currency, so a rise in the exchange rate is a depreciation, a fall in the value, of the domestic currency).5 Thus, current expectations of a higher future price level imply current expectations of a higher future exchange rate. But those expectations of a higher future exchange rate would imply a higher current exchange rate, a current depreciation of the currency. The reason is that, at a zero domestic interest rate, the exchange rate must be expected to fall (that is, the domestic currency must be expected to appreciate) over time approximately at the rate of the foreign interest rate. Only then is the expected nominal rate of return measured in domestic currency on an investment in foreign currency equal to the zero nominal rate of return on an investment in domestic currency; this equality is an approximate equilibrium condition in the international currency market. That is, the current exchange rate must approximately equal the expected future exchange rate plus the accumulated foreign interest (the product of the foreign interest rate times the time distance between now and the future). But then, at unchanged domestic and foreign interest rates, the current exchange rate will move approximately one to one with the expected future exchange rate. If the expected future exchange rate is higher, so is the current exchange rate. Indeed, the whole expected exchange-rate path shifts up with the expected future exchange rate. Thus, we have clarified that the optimal policy to escape from a liquidity trap, which involves expectations of a higher future price level, would result in an approximately equal current depreciation of the currency.

This has the important consequence that the current exchange rate immediately reveals whether any policy to escape from a liquidity trap has succeeded in creating expectations of a substantial increase in the future price level. If it has, this appears as a substantial current depreciation of the currency. Consequently, if the currency does not depreciate substantially, the policy has failed. Regarding Japan, from 1999 to the summer of 2003, the yen has fluctuated in the interval 105–130 yen per dollar with an average of about 117. In the year prior to the summer of 2003, the average rate has been about 120. Hence, there has not been any substantial depreciation. Consequently, any policy in Japan, including the quantitative easing with the 50 percent expansion of the monetary base in the two years to the summer 2003, has apparently not succeeded in any substantial increase in the expected future price level.

However, the desired initial depreciation of the currency can be achieved directly by the central bank. Indeed, the central bank can directly achieve the desired optimal exchange-rate path associated with the optimal policy to escape from the liquidity trap. The initial depreciation of the currency will then induce private-sector expectations of a future depreciation and, importantly, of a higher future price level, the crucial element in escaping from a liquidity trap. Thus, by a current depreciation of the currency, the central bank can induce private-sector expectations of a higher future price level and in this way make its commitment credible.

For simplicity, the discussion here is in terms of a central bank that controls both monetary policy and exchange-rate policy. In many countries, including the United States and Japan, the responsibility for exchange-rate policy rests with the department of the treasury or the ministry of finance rather than the central bank. This situation is problematic, a potential source of conflict and unclear responsibilities, and even a potential threat to central-bank independence, since monetary and exchange-rate policy are, under free international capital mobility, not independent but just two sides of the same coin. Because of such institutional imperfections, exchange-rate policy as discussed here must in many countries actually be done in cooperation between the central bank and the department of the treasury/ministry of finance.

Let us take the argument step by step. First, how can the central bank achieve the desired initial depreciation of the currency and implement the desired exchange-rate path? It can do this by announcing a crawling peg: a new high initial exchange rate and the gradual fall over time of the exchange rate at a fixed rate approximately equal to the average foreign interest rate. In particular, the central bank should announce that it will buy and sell unlimited amounts of foreign exchange at the announce exchange rate. If this crawling peg would fail, the domestic currency would appreciate back to the vicinity of the exchange rate before the announcement, making the currency a good investment. Thus, initially, before the peg’s credibility has been established, there will be excess demand for the currency. This demand is easily fulfilled, however, since the central bank can print unlimited amounts of its currency and trade it for foreign exchange.6

Remember, it may be difficult and even impossible to defend the peg of a currency under pressure for depreciation, because the central bank must sell off its foreign exchange reserves to support the currency and those reserves eventually run out. In contrast, it is easy to defend a peg of a currency under pressure for appreciation, because this defense calls for the bank to issue more domestic currency and hold greater foreign-exchange reserves, which it can without limit. Thus, the peg can be defended and the peg’s credibility will soon be established.

Second, why would the peg induce expectations of a higher future price level? Once the peg is credible, since the expected exchange-rate path has shifted up by the initial depreciation, the private sector must believe that the future exchange rate will be higher. But then internal consistency requires that the private sector must also expect a higher future price level (since they have no reason to believe that the future relative price between domestic and foreign goods will move in any particular direction). Thus, the initial depreciation, the credible peg and internal consistency forces the private sector to expect a higher future price level.

Thus, the initial depreciation and the crawling peg gives the central bank a concrete action by which it can demonstrate its commitment and induce the desired private-sector expectations. Depending on how quickly the peg becomes credible, the central bank may have to buy more or less foreign exchange, thus adding to its foreign exchange reserves. Interestingly, the existence of these reserves gives the central bank an internal balance-sheet incentive to maintain the peg, since abandoning the peg and allowing the currency to depreciate back to its initial level would result in a capital loss for the central bank. Thus, the central bank is actually putting its money where its mouth is, thereby reinforcing the commitment.

The argument can be further illustrated in figure 1. The horizontal axis shows time; the current period is denoted by 0 and the future is denoted by T. The vertical axis displays (the logarithm of) the price level and the exchange rate. Initially, the current price level is p0 and deflation and the liquidity trap would gradually bring the price level down to the level pT in the future, corresponding to the downward-sloping line p0pT. Initially, the current exchange rate is s0, and it is expected to fall at the rate of the foreign interest rate to sT in the future, corresponding to the downward-sloping solid line s0sT. The lines p0pT and s0sT need not be parallel, since the rate of deflation need not equal the foreign interest rate.

Suppose that the optimal way to escape from a liquidity trap involves the higher future price level pT’, higher than the future price level pT, and a price-level path corresponding to the upward- sloping dashed line p0pT’. The problem for the central bank is to make this higher future price level be credible, that is, expected by the private sector in the current period, so the private-sector's inflation expectations are sufficiently high, corresponding to the positive slope of the line p0pT’ rather than the negative slope of the line p0pT. The exchange-rate path consistent with the optimal way to escape from the liquidity trap is s0’sT’, a parallel shift up of s0sT by the same magnitude that the higher future price level pT’ exceeds pT.

By raising the initial exchange rate from s0 to s0’ and defending and establishing credibility for a crawling peg along s0’sT’, the central bank induces expectations of the future exchange rate equal to sT’ and of the future price level equal to pT’. Once the crawling peg is credible, the private sector cannot expect a lower exchange rate (stronger currency) in the future than sT’, since that would require a negative domestic interest rate. Any deterioration of the credibility of the peg would immediately show up in appreciation pressure on the currency, that is, a pressure downwards on the exchange rate and increased demand for domestic currency. But the central bank can immediately counter this by issuing more currency and buying more foreign exchange, thus restoring the credibility of the peg.

Suppose that the central bank would announce not a crawling but a constant peg at the level s0’. This would correspond to a horizontal line at the level s0’ in figure 1. Once the central bank had established credibility for that constant peg, the private sector would expect the future exchange rate to equal s0’. This would imply expectations of a higher price level than the optimal pT’, higher than pT’ by the same magnitude as s0’ exceeds sT’. Thus, this would correspond to a higher-than- optimal future price level. Furthermore, the constant peg would not be consistent with a zero domestic interest rate; instead the domestic interest rate would have to be raised to equal the foreign interest rate (in order to fulfill the equilibrium condition of approximate equality of the expected rate of return on investments in domestic and foreign currency mentioned above). But, the higher expected future price level and thereby higher expected inflation compensates for the higher interest rate, so the real interest rate would still equal the optimal one. The central bank could avoid the too high future price level by announcing a constant peg at a lower exchange rate than s0’, but then the inflation expectations would be lower, and with the domestic interest rate still equal to the foreign one, the domestic real interest rate would be higher than optimal one, making the current recession deeper. Thus, the crawling peg with an appreciating exchange rate and a zero domestic interest rate provides the best tradeoff between current output and the future price level.

Several papers have suggested that the central bank depreciate the currency by general foreign- exchange intervention; that is, by buying foreign-currency assets (foreign Treasury bills) and selling (paying with) domestic currency. This process increases the supply of assets denominated in domestic currency and reduces the supply of assets denominated in foreign currency. If domestic- and foreign-currency-denominated assets are imperfect substitutes, this process induces a depreciation of the domestic currency. The effect of relative asset supplies on the exchange rate is called the “portfolio-balance effect” in the literature. However, most empirical estimates of the size of any portfolio-balance effect have been quite small, and the practical importance of portfolio- balance effects is a matter of controversy (Sarno and Taylor (2001)). Consequently, it is difficult to predict how effective foreign-exchange interventions would be and what magnitude of intervention would be needed. Fortunately, the above implementation of the crawling peg as a commitment to buy and sell unlimited amounts of foreign exchange at the announced exchange rate does not rely on the existence of any portfolio-balance effects.

McCallum (2000, 2002, 2003) has proposed a moving exchange-rate target rather than an exchange-rate peg as a way to escape from a liquidity trap. The moving exchange-rate target would be a function of current inflation and the output gap, such that inflation below the inflation target or a negative output gap would result in a currency depreciation. McCallum has shown in simulations with an open-economy model that this moving exchange-rate target, if it is credible and understood by the private sector, can stimulate the economy out of a liquidity trap and deflation. This proposal implies a more indirect and more complex commitment to a higher future price level, although it could perhaps be combined with a price-level target path and an exit strategy when the price-level target path has been reached.7

A currency depreciation has proven to be an effective tool for fighting deflation in the past. As Bernanke (2002) notes: “A striking example from U.S. history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933–34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from −10.3 percent in 1932 to −5.1 percent in 1933 to 3.4 percent in 1934.”

The Foolproof Way


The previous discussion of the optimal policy and the practical proposals indicate three elements of a successful escape from a liquidity trap: 1) a commitment by the central bank to a higher future price level, preferably in the form of a price-level target, including any price-gap that the central bank prefers to undo; 2) a concrete action by the central bank that demonstrates its commitment to the higher future price level, induces corresponding private-sector expectations and reduces the real interest rate; and 3) an exit strategy that specifies when and how to get back to normal (and what that “normal” is). My proposal, the Foolproof Way to escape from a liquidity trap, attempts to combine these three elements (Svensson (2001)). Although this proposal was originally directed toward Japan, it applies to any open economy, that has fallen into a liquidity trap, and, should it be necessary in the future, would work well for both the United States and the euro area.

The Foolproof Way consequently consists of announcing and implementing three measures: 1) an upward-sloping price-level target path, starting above the current price level by a price gap to undo; 2) a depreciation and a crawling peg of the currency; and 3) an exit strategy in the form of the abandonment of the peg in favor of inflation or price-level targeting when the price-level target path has been reached.

As discussed in the previous subsection, a currency depreciation and a crawling peg is unique in providing the central bank with a concrete action that demonstrates the central bank’s commitment to a higher future price level, establishes credibility for the peg, induces private-sector expectations of a higher future price level, and stimulates the economy by reducing the real interest rate. As argued, via a depreciation and a crawling peg with a rate of appreciation approximately equal to the average foreign interest rate, the central bank can actually implement approximately the optimal way to escape from a liquidity trap and strike the optimal balance between current stimulus of the economy and the future price level.8 Furthermore, as discussed, the exchange rate is unique in providing a relatively direct measure of the private-sector expectations of the future price level.

Once the Foolproof Way is implemented, the currency depreciation and the lower real interest rate will increase aggregate demand, jump-start the economy, and increase output towards potential. The depreciation, the closing of the output gap and the increased inflation expectations will increase the domestic price level (the GDP deflator). Finally, the consumer price index, as distinct from the GDP deflator, will increase not only from the increased GDP deflator but also from increased costs of imported final goods because of the currency depreciation.9 The domestic pricelevel will approach the price-level target path from below. When the price-level target has been reached, according to the exit strategy, the exchange-rate peg is abandoned, and the economy can get back to normal with the central bank adopting some form of inflation or price-level targeting.

Conclusion


The proposals to escape from a liquidity trap and deflation discussed in this paper provide a number of alternatives that can be used. Several of these proposals could be used simultaneously, in the hope that something works. The Bank of Japan has not followed any of these recommendations, except expanding the monetary base. The failure of the Bank of Japan to undertake more genuinely expansionary policy, especially to take the initiative to cooperate with the Ministry of Finance to depreciate the currency, has led to widespread frustration among commentators. As expressed by Svensson (2001) (written before the futile quantitative easing): “The gist of the Bank of Japan’s argument [against more expansionary policy] ... seems to be that, 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.”

A recent paper by Coenen and Wieland (2003) presents a very interesting comparison of three methods for Japan to escape from deflation and the liquidity trap. The paper compares the Orphanides and Wieland’s (2000) proposal to expand the monetary base, McCallum’s moving exchange-rate target, and my Foolproof Way in an estimated and calibrated three-region model of Japan, the United States and the euro area. All three methods work in lifting Japan from recession and deflation, with small negative consequences for inflation and unemployment in the other two regions. However, this model assumes that all three methods are equally and fully credible, which is not necessarily the case, as discussed in some detail above.10

If either of the United States or the euro area would fall into a liquidity trap in the future, would the Foolproof Way work for them, too? Everything else equal, the more open an economy, the more sensitive it should be to a depreciation of the currency. Of these three economies, Japan is the least open economy, measured as the share of trade in GDP. Its export and import were, respectively, about 11 and 10 percent of GDP in 2001. For the euro area, these shares were about 20 and 19 percent; for the United States they were about 10 and 14 percent (European Central Bank (2003)). Thus, the United States and the euro area should be at least as sensitive to exchange-rate movements as Japan.

The simple version of the Foolproof Way discussed above takes the rest of the world as given. For instance, it is assumed that interest rates and inflation in the rest of the world is approximately unaffected. If the country that follows the Foolproof Way is too large relative to the rest of the world, this may not be the case. Of the three regions, Japan has the smallest GDP, a share of about 12 percent of world GDP at market exchange rates in 2002 (about 7 percent at purchasing-power- adjusted GDP; International Monetary Fund (2003b)). The shares of the euro area and the United States are about 21 and 33 percent, respectively (16 and 21 percent, respectively, at purchasing-power-adjusted GDP). Thus, the United States, the largest economy in the world, produces no more than a third of the world’s GDP (and only about a fifth if we use purchasing-power-adjusted GDP). If the United States were to follow the Foolproof Way, interest rates and inflation in the rest of the world would not be unaffected, but they may not move that much either; if the euro area were to follow the Foolproof Way, they would clearly move less. The optimal way to escape from a liquidity trap for the euro area or the United States would involve expectations of a higher future price level which would be induced by the three elements of the Foolproof Way in the same way as they would for Japan. I conclude that the Foolproof Way is likely to be an effective way to escape from a liquidity trap and deflation for both the euro area and the United States.

There are two final issues to address about currency depreciation as a way to escape from a liquidity trap, like the Foolproof Way. First, a policy that calls for a depreciation relative to the rest of the world can work for Japan, or the United States, or the euro area, but if all three regions were simultaneously to fall into a liquidity trap, these regions could not all simultaneously depreciate against each other. However, if only one of them is in a liquidity trap, as is currently the case for Japan, it can apply the Foolproof Way and escape the liquidity trap. Having escaped, it then leaves any other region free to apply the Foolproof Way in the future, should that region be so unfortunate as to fall into a liquidity trap.

The second issue is whether escaping a liquidity trap via a currency depreciation has negative consequences for the trading partners of the country. When a country attempts to stimulate its economy by depreciating its currency, this is often called a “competitive devaluation” or a “beggar- thy-neighbor policy,” invoking associations of negative consequences for trading partners. For instance, Fischer (2001) suggests that a yen depreciation could not be pushed too far because of beggar-thy-neighbor concerns.

However, we have already seen that the optimal way to escape from a liquidity trap, which involves expectations of a higher future price level, would directly lead to a corresponding depreciation of the currency. Indeed, absence of a currency depreciation indicates a failure to induce such expectations. The Foolproof Way is just a method to implement approximately the optimal way to escape from the liquidity trap through the back door, by starting with a currency depreciation. Indeed, any expansionary monetary policy that succeeds in increasing expectations of the future price level and lowering the real interest rate will imply a currency depreciation. Thus, opposing a currency depreciation is an argument against any expansionary monetary policy – which seems nonsensical.

Because of the short-run stickiness of the domestic price level, a currency depreciation implies a temporary real currency depreciation, that is, an increase in the price of foreign goods relative to domestically produced goods and services. This is a terms-of-trade improvement for the trading partners and in itself beneficial to them. But one concern is that this will increase the domestic trade balance, the net export from the country and hence decrease the net export to the country from the trading partners. But the effect on the trade balance involves both a substitution and an income effect, of opposite signs. The substitution effect due to the change in relative prices from a depreciation favors domestic exporters and import competitors and increases the trade surplus (or reduces the trade deficit). But the income effect due to increased output, consumption and investment in the domestic economy implies increased import of raw materials, intermediate inputs and final goods and reduces the trade surplus (or increases the trade deficit). The net effect on the trade balance may therefore be quite small, as indicated by simulations in Coenen and Wieland (2003) and McCallum (2003). Thus, a currency depreciation will involve some sectoral shifts, but it need not involve any beggar-thy-neighbor policy. For Japan, with an economy operating far below potential GDP, the income effect on the trade balance, which is favorable to the trading partners, could actually be quite large.

Furthermore, and importantly, to the extent that the Foolproof Way has any contractionary effects and reduces output and inflation in the rest of the world, the rest of the world can respond with lower interest rates and monetary expansion. In this way, a desirable world-wide monetary expansion is implicitly coordinated by countries pursuing domestic monetary objectives, as is discussed recently by Obstfeld and Rogoff (2002), Corsetti and Pesenti (2003), and Benigno and Benigno (2002).11

Generally, it should be an obvious world priority to end the decade-long stagnation and recession in Japan, the world’s second largest economy. Concern about relatively minor effects of a currency depreciation should be irrelevant to this overall priority. It seems obvious that the East-Asian region, the United States, and the world as a whole would all benefit in the medium and long term from a Japanese recovery and a strong Japanese economy.

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