NBER Reporter: Spring 2000

Monetary Policy in a Low Inflation Environment

The NBER, London's Centre for Economic Policy Research, and The Tokyo Center for Economic Research

The NBER, London's Centre for Economic Policy Research (CEPR), and the Tokyo Center for Economic Research (TCER) jointly sponsored a conference on "Monetary Policy in a Low Inflation Environment" in Tokyo on December 16 and 17. Takeo Hoshi, TCER and University of California, San Diego, and Sadao Nagaoka, TCER and Hitotsubashi University, organized this program:

Kenji Nishizaki, Bank of Japan, and Tsutomu Watanabe, Hitotsubashi University, "Output-Inflation Tradeoff at Near-Zero Inflation Rates"
Discussants: Kenichi Ohno, Asia Development Bank Institute, and Eric Rosengren, Federal Reserve Bank of Boston

Athanasios Orphanides and Volker Wieland, Federal Reserve Board of Governors, "Efficient Monetary Policy Design at Near Price Stability"

Discussants: Fumio Hayashi, NBER and University of Tokyo, and Kiyohiko G. Nishimura, University of Tokyo

Harald Uhlig, CEPR and Tilburg University, "Should We Be Afraid of Friedman's Rule?"
Discussants: Kyoji Fukao, Hitotsubashi University, and Nobuhiro Kiyotaki, London School of Economics

Richard H. Clarida, NBER and Columbia University, "G3 Exchange Rate Relationships: A Recap of the Record and a Review of Proposals for Change" (NBER Working Paper No. 7434)
Discussants: Hiroshi Fujiki, Bank of Japan, and Nikolaos Panigirtzoglou, Bank of England

Ryuzo Miyao, Kobe University, "The Role of Monetary Policy in Japan: A Break in the 1990s?"
Discussants: Takeo Hoshi and Michael Hutchison, University of California, Santa Cruz

Kazuo Ogawa, Osaka University, "Monetary Policy, Credit, and Real Activity: Evidence from the Balance Sheet of Japanese Firms"
Discussants: Joe Peek, Federal Reserve Bank of Boston, and Shigenori Shiratsuka, Bank of Japan

Paul Krugman, NBER and MIT, "Three Views on Liquidity Traps and Policy Implications"
Discussants: Yosuke Takeda, Sophia University, and Hiroshi Yoshikawa, TCER and University of Tokyo

Motoshige Itoh and Naoki Shimoi, University of Tokyo, "On the Role of Monetary Policy in a Deflationary Economy"
Discussants: John Driffill, University of Tokyo, and Mitsuhiro Fukao, Keio University

Japanese consumer price index (CPI) inflation rates have been declining since the first quarter of 1991. Ranging only between zero and 1 percent in 1996 and 1997, the CPI inflation rates have been negative since the third quarter of 1998. Using Japanese data, Nishizaki and Watanabe provide new evidence about the cost of near-zero inflation. In particular, they are interested in the relationship between the rate of inflation and the slackness of the economy, that is, the short-run Phillips curve. The authors construct a panel dataset consisting of the rate of inflation and the ratio of job offers to applicants in 46 prefectures from 1971 to 1997. After eliminating the effects of nationwide shocks, including changes in expectations about the future course of monetary policy, they find that the slope of the short-run Phillips curve does become smaller as the rate of inflation approaches zero. In particular, the estimated slope is smaller in the 1990s than it was before that time.

Orphanides and Wieland study the design of monetary policy in a low inflation environment, taking into account the limitations imposed by the zero bound on nominal interest rates. They focus on the portfolio balance channel through which changes in relative money supplies influence the exchange rate. They find that the optimal policy near price stability (close to zero inflation) is asymmetric: that is, as inflation declines, the policy turns expansionary more quickly and aggressively than would be optimal if there were no zero bound on nominal rates. As a result, the average level of inflation is biased upwards. Thus, policymakers are faced with a tradeoff between the level of inflation and economic stabilization when the economy is operating near the zero bound. The authors also discuss some operational issues associated with the interpretation and implementation of policy at the zero bound in relation to Japan's recent situation.

Uhlig attempts to gain more insight into liquidity traps, Friedman's rule, and runaway deflation. He first finds that Friedman's rule can be implemented by shrinking the money stock at the appropriate rate over the long run. Therefore, increases in the money stock -- be they through outright "helicopter drops," through any type of open market operation, or through foreign exchange intervention -- change nothing as long as the economy remains in the equilibrium of a long-run shrinkage of the money stock. Next, Uhlig examines two simple reduced form models of the inflationary process, one inherently unstable and the other inherently stable. Neither model yields plausible results. Finally, Uhlig considers a formal "baby-sitting coop" model, taking up a line of argument promoted by Krugman (1999). This model yields multiple equilibriums but can make matters worse in terms of liquidity. Thus, Uhlig challenges the conventional wisdom: that liquidity traps are bad.

Clarida reviews G3 exchange rate relationships since the collapse of Bretton Woods and analyzes recent proposals for changing the way the G3 countries conduct exchange rate policy. Advocates of these proposals have assessed the global costs of exchange rate volatility and exchange rate misalignments, and find the status quo unacceptable. They believe that a sustained effort to limit G3 exchange rate fluctuations would deliver benefits to the world economy that would outweigh the value of any lost monetary autonomy in the G3 required to maintain such a system. The skeptics make a positive, not a normative, judgment that the sorts of proposals that are on the table will not circumvent the "impossible trinity" of international finance.

Miyao documents time-series evidence suggesting the case for a possible structural break in the role of Japan's monetary policy during the 1990s. While he detects a persistent effect of monetary policy on real output both between 1975 and 1998 and during the period ending in 1993, that effect disappears in the most recent subsample of the 1990s. There is also more specific evidence of a break in the reduced form dynamic system in 1995. Miyao offers some interpretations that intuitively support this empirical evidence.

Ogawa analyzes the mechanism of monetary transmission in the Japanese economy. Using quarterly time-series data disaggregated by firm size, he examines the channels through which monetary policy influences the important items on the firms' balance sheets: land stock, long-term loans, and capital stock. His evidence supports the credit channel of monetary transmission. He also finds that land has played a vital role in monetary transmission, especially for small firms. Moreover, Ogawa shows that the large number of bad loans caused by excessive lending secured by land constrains the lending behavior of commercial banks and weakens the efficacy of monetary policy.

Krugmanshows that the liquidity trap is not an artifact of the IS-LM model's incompleteness: even in a "modern" macroeconomic model based on intertemporal utility maximization by a representative agent, the liquidity trap can arise. Krugman argues that fiscal expansion or unconventional monetary policy would be sufficient to overcome the liquidity trap if it is only temporary. But if the liquidity trap is structural, as he believes to be the case for Japan, then inflation targeting aimed at changing expectations may be the only effective policy.

Like Krugman, Itoh and Shimoi suggest that Japan is in a liquidity trap. They describe "adjustment inflation policy" (chosei inflation), which was advocated in Japan during the early 1980s, and show that generating inflation or inflationary expectations is helpful not only in the context of Krugman's argument but also in reducing debt burdens in the private and public sectors. To create inflation or inflationary expectations with a liquidity trap, the Bank of Japan could pursue unconventional monetary policy, for example buying long-term government bonds or targeting the inflation rate to be higher than actual inflation.

These papers will be published in a special issue of the Journal of the Japanese and International Economics. Takeo Hoshi and Sadao Nagaoka will be guest editors of the issue. In advance of the publication of the journal, most of these papers will be available at Books in Progress.

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