International Creditors under the World Dollar Standard: Japan

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International Creditors under the World Dollar
StandardJapans Liquidity Trap Redux

• Ronald I. McKinnon (Stanford)
• Rishi Goyal (IMF)

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Thesis Conflicted Virtue

• Creditor economies with
• history of current account surpluses and
• build up of liquid foreign currency claims
• could face deflation and a liquidity trap
• Obvious example Japan
• However, China and other East Asian creditors may
  follow

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Thesis described (1)

• The world is on a dollar standard
• creditor economies build up claims on rest of the
  world in dollars
• Exchange rate fluctuation (or anticipated
  appreciation)
• domestic currency value of dollar holdings
  fluctuates or may fall
• risky to hold dollar assets
• dollar assets must pay premium
• domestic interest rates lower than U.S. rates

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Thesis described (2)

• Risk premium could be large
• e.g. Japan where financial institutions
  intermediating the claims have net worth close to
  the regulatory minimum
• Continued build up of dollar claims
• domestic interest rates could decline to low
  levels
• economy could fall into liquidity trap

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Thesis described (3)

• In liquidity trap
• monetary policy ineffective to halt deflation
• bank credit to private credit slumps
• profit margins on lending low/negative
• so, investment weakens
• banks unable to recapitalize themselves may need
  successive bailouts
• portfolio reallocation private sector sells
  foreign currency assets and purchases domestic
  currency assets
• central bank purchases foreign currency assets
• ? large buildup in foreign currency reserves

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• Investment is weak at low interest rates

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Model (1)

• Modification of Mundell-Fleming
• Asset market equilibrium
• i i Dse j (S NfxA/A ss)
• Money market equilibrium
• Ms/P L(i, Y)
• (perfectly elastic at low interest rates)

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Model (2)

• Goods market equilibrium
• Y C(YT, ipera)I(i,pe)GNX(q,YT)
• Real exchange rate and inflation
• q S P/P
• pe Dse pe Dqe(Y Yf)
• Foreign asset accumulation
• Ft1 (1i) Ft NXt (Pt/St)

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Rest of the paper

• Analysis of the model
• outside and inside the liquidity trap
• sterilized and unsterilized interventions
• changes in the world real interest rate
• Application to
• Japan, China, other East Asian creditors
• ongoing U.S. current account deficits
• Policy conclusions