52

IS-LM-FE model• General Equilibrium model

all makets are in equilibrium at the same time

• Three markets only1. goods 2. money 3. nonmoney assets

• Three steps1. Investigate demand for output and construct IS curve

2. Determine willingness to hold money and construct LM curve

3. Examine willingness to supply the output and construct FE line

IS curve• Aggregate Demand = C + I + G + NX

• Equilbrium on the goods market: Y = Aggregate Demand

• Income/GDP identity : Y = Income = C + S + NT

• C + S + NT = C + I + G + NX

• S + NT = I + G + NX

Assume, (1) closed economy NX = 0

(2) balanced budget NT = G

• S = I

National Saving = National Investment

National Investment1. Expected real interest rate (expected)

2. Expected future profitability of capital

National Saving 1. Current disposable income

2. Future disposable income

3. Government purchases

4. Real interest rate (expected)

I

S

I

Real

i

Y

S

S = I + G – NT + NX

Government Purchases G� => S�, I�

Export� => NX� => S�, I�

Import� => NX� => S�, I�

Willingness to save => S�

Expected profitability of capital => I�

Currency Depreciation => NX� => S�, I�

Y

Real i

IS0

IS1

LM curve• Asset Market Equilibrium (stocks, bonds, …)

• Wealth is divided between money (M) and nonmoney (N) assets

Md + Nd = W =Ms + Ns

Md - Ms = Ns - Nd = 0 in equilibrium

• Ms given by central bank (and price level) :

Ms = nominal money balances / level of prices

• Md determined by

Transactions motive — positively related to Y

Precautionary motive — positively related to Y Speculative motive — negatively related to i

KEYNES FRIEDMAN

Md

i

Md

i

Equilibrium : Ms = Md = LY + Li

Li … demand for money due to the speculative motive

LY … demand for money due to the transaction and the precautionary motives

Li

LY

Y

LY

Li

Real

i

Nominal money balances� => Ms�

Aggregate price level � => Ms�

Expected inflation � => Md�

Y

Real

i

LM0

LM1

IS curve

S

I

Real i

Y

LY

Li

Real i

Y

LM curve

S = I + G – NT + NX Ms = Li +LY

NOTES 1 Chapter 20

53

FE - Full Employment Line

IS curve illustrates combinations of the level of current real

output and real interest rate for which the goods market is in

equilibrium. The long run output is given by available resources

(capital, land and labor) and applied technology.

Assuming that the new investments

only increase future levels of capital

stock (and applied technology), the

actual current output is given by the

used level of labor.

Hence full employment output (=

potential Y) can be illustrated by by

the FE line. Intersection between IS

and FE represents long run goods

market equilibrium.Y

Real iFE

IS

Y*

i*

Fiscal Policy Expansion

Y

Real iLM0

IS1

Y

Real i FE

E1

Short Run

Equilibrium

LM0

IS1

In the short run,

an increase in G or a

decrease in NT

increases GDP and

real interest rate.

In the long run,

prices increase,

thus the real supply of

money decreases. The

equilibrium output is

given by the potential

output, real interest

increases increases

even more.

FE

IS0

IS0

LM2

E2

Long Run

Equilibrium

Keynes and Liquidity Trap

Y

Real i LM1IS0

E0 = E1

Short Run

Equilibrium

E1

Short Run

Equilibrium

LM0

Y

Real i IS0 LM0IS1

LM curve has a flat

part, thus an increase

of Ms, that shifts LM

to the right, does not

have any impact on

GDP.

On the other hand,

Fiscal policy

Expansion works

great. Since it has a

limited impact on

interest rates, I is not

crowded out.

IS-LM-FE

Too little

unemployment,

price level

increases

Y

Real iLM

Y

Real i

IS

Y

Real i FE

Y*

Too much

unemployment,

price level

decreases

Excess demand

for goods

Excess supply

of money

Excess supply

of goods

Excess demand

for money

Monetary Policy Expansion

Y

Real iLM1

IS0

Y

Real i FE

E1

Short Run

Equilibrium

LM1

IS0

In the short run,

an increase in nominal

money balances

increases Ms and GDP

and decreases the real

interest rate.

In the long run,

as prices increase,

the real supply of

money decreases.

GDP and real interest

rate return to its

original levels.

FE

LM2=LM0

E2

Long Run

Equilibrium

LM0

Monetarists

Y

Real i LM1IS0

E1

Short Run

Equilibrium

E1

Short Run

Equilibrium

LM0

Y

Real i IS0 IS1

LM curve is steep,

thus an increase of Ms

increases GDP.

On the other hand,

Fiscal policy Expansion

does not work – Since it

only increases

the interest rate,

an increase of

government purchases

results in private

investment I

being crowded out by it.

LM0

Equilibrium

Y

Real i LM

IS

Y

Real i FE

Y*

Long Run Equilibrium

Short Run Equilibrium

LM

IS

In the short run,

Fiscal policy (IS) and

Monetary policy (LM)

can change the

equilibrium output

and interest rate.

In the long run,

equilibrium output is

given by the potential

output (available

resources and

technology)

The following article discusses the ineffectiveness of monetary policy to stimulate Japan's economy

and compares a liquidity trap argument that policy ineffectiveness results from near zero interest rates

with a credit crunch view stressing the contribution of Japanese banking problems to policy impotence.

It finds the credit crunch a better explanation of events.

1. What is a liquidity trap? How and why does it affect the power of expansionary monetary

policy to stimulate the economy?

2. Why does Paul Krugman believe Japan is in a liquidity trap? What monetary policy action

does he advocate to remedy the situation?

3. How does the credit crunch view explain the inability of monetary policy to revive the

Japanese economy? What evidence supports this view rather than Krugman's liquidity trap

view as the better explanation of policy ineffectiveness in Japan?

54

FRBSF Economic LetterFRBSF Economic LetterFRBSF Economic LetterFRBSF Economic Letter

2000-19; June 16, 2000

Japan's Recession: Is the Liquidity Trap Back?

Since the early 1990s, rising unemployment, price deflation, sluggish growth, and

even recession have beleaguered Japan. The country's central bank, the Bank of

Japan (BOJ), has responded by lowering interest rates to stimulate demand. Short-

term rates, shown in Figure 1, were gradually lowered from 8.3% in early 1991 to

virtually zero by early 1999 and have stood at that level for more than a year. By

mid-1999, the two-year government bond rate was only 0.48% and the corporate

bond rate was 0.80%.

With interest rates at historic

lows, why is the Japanese

economy still in a slump? One

explanation, put forward by

Paul Krugman (1998a, b), is

that traditional monetary policy

instruments are powerless to

provide effective stimulus to

the economy because Japan is

in a "liquidity trap." This

Economic Letter evaluates the

liquidity trap argument against

a leading alternative

explanation: a credit crunch

associated with Japan's banking

problems.

Liquidity traps Japan is the first major

industrial economy to face

serious deflation since the 1930s, and, not surprisingly, that also was the time that

the liquidity trap explanation for the ineffectiveness of monetary policy was

popularized. A liquidity trap is characterized by a situation--similar to Japan today--

where interest rates are at or near zero. Monetary policy is seemingly impotent to

stimulate demand and raise spending since interest rates are already at the lowest

point possible--no one would normally be willing to hold bonds with negative yields

over (zero interest-bearing) money.

Is Japan in a liquidity trap? Krugman (1998a) forcefully argues this case and

suggests a specific and unorthodox policy recommendation--that the BOJ bring

inflation and inflationary expectations up to 4% and keep them there for 15 years

(see Spiegel 2000). The key element of Krugman's analysis is that the equilibrium

real interest rate--that is, the real rate that would match saving and investment--is

negative in a liquidity trap. How could the equilibrium real interest rate be negative?

Because poor long-run growth prospects, which, in Japan's case, presumably are

linked to unfavorable demographic trends, make investment demand so low that a

negative short-term real interest rate would be needed to match saving with

investment. Given a nominal interest rate floor of zero, Krugman argues that a

positive expected rate of inflation is necessary to generate negative real interest

rates, which will stimulate aggregate demand and restore full employment.

Krugman draws on two bits of empirical evidence to support the liquidity trap

argument. First, he points to the fact that short-term interest rates have reached a

minimum point, virtually zero. Moreover, the yield curve has been virtually flat, as

the 10-year government bond yield declined to less than 1% for a brief period in late

1998. The low interest rates seen in Japan at the end of the 1990s are unprecedented

for any major industrial country since the 1930s.

Second, Krugman points out that injections of liquidity by the central bank have not

been very effective in raising the growth rate of the broader money aggregates. He

shows that the monetary base grew 25% from 1994 to 1997, but that the broader

monetary aggregate (M2 + CDs) grew only 11%, and bank credit grew not at all.

And more recent statistics indicated that "money hoarding" continued to be evident

in 1998-1999, as an expansion of the monetary base in the range of 8% to 10%

resulted in only about a 3% growth in M2 + CDs. Bank lending has collapsed since

early 1998, as shown in Figure 2. Moreover, low interest rates and expansion in the

monetary base had not helped increase aggregate demand--the economy continued

in recession.

Alternative explanation: the

credit crunch The main alternative

explanation for the

ineffectiveness of monetary

policy to stimulate the

economy is the "credit crunch"

view. This explanation focuses

on the contraction of the supply

of bank credit (credit crunch)

caused by massive

nonperforming loans

accumulating in the financial

system.

This argument has two parts.

The first focuses on the decline

in bank capital due to the

accumulation of bad loans held

by Japanese banks. The capital

asset ratio of the 20 largest financial institutions in Japan fell significantly between

1994 and the end of 1998. Less than candid reporting initially both by banks and by

the Ministry of Finance about the magnitude of the nonperforming loan problem

NOTES 2

55

made it difficult for banks to raise capital in domestic and international financial

markets. They therefore responded by reducing the amount of loans. Japanese

financial institutions have attempted to raise capital-asset ratios, in part in response

to recently tightened international capital standards, as well as in response to

pressure from the markets and the government. But building capital-asset ratios by

restraining lending takes a long time. And it induces a credit squeeze in the process-

-the origins of the credit crunch in Japan.

The second part of the credit crunch explanation focuses on the cautious lending

attitude of Japanese banks following their recent experience with bankruptcies,

nonperforming loans, and recession. Liabilities associated with bankruptcies hit an

all-time high of 2.7 trillion yen in October 1997, and a trend line shows a sustained

rise to the highest point in the postwar period towards the end of the decade. These

circumstances make firms less desirable potential borrowers than they used to be,

from the banks' point of view. And they also have the self-reinforcing effect of

tightening credit conditions and worsening the recession.

Evidence of a credit crunch also is suggested by the BOJ survey known as Tankan.

This survey asks firms their views of the "lending attitude of financial institutions."

Despite the low interest rate environment, the survey indicates a sharp tightening of

credit conditions in Japan since mid-1997 facing both large and small enterprises.

The "lending attitudes" of financial institutions, at least from the borrower's

perspective, have become much more stringent.

A credit crunch implies that injections of liquidity (base and narrow money

expansion) do not increase credit and aggregate lending. This is exactly what has

occurred in Japan. Base and narrow money have increased at a robust pace in 1997-

1999, but the broader money aggregates most directly related to spending in the

economy grew modestly. Most disturbing is that aggregate lending by banks has

decreased sharply, the flip side of which is the tightening of credit conditions faced

by enterprises in Japan.

Which is right? Krugman (1998a) dismisses the credit crunch argument, arguing that banks with a

large portfolio of nonperforming loans should take on excessive risk and stand ready

to lend even to questionable borrowers. Excessive lending, rather than a credit

contraction, would be predicted, as banks gamble on high-risk projects, hoping to

restore solvency before they are forced into bankruptcy by the financial authorities.

This type of excessive lending occurred in Japan at the early stages of the banking

crisis. Lending by real estate lending institutions, known as jusen, actually grew

rapidly in 1991-1992, as they faced growing problems with nonperforming loans

(Cargill, Hutchison, and Ito 1997). But at the current stage of the banking problem--

with the creation of a new Financial Supervisory Authority, greater transparency,

and more disclosure on loan positions--the supervisory authorities are not sitting by

idly and allowing excessive risk-taking on the part of banks. Greater stringency in

banking oversight is the new modus operandi in Japan since 1998 (Cargill,

Hutchison, and Ito, forthcoming).

The balance of evidence seems to support the credit crunch explanation of why

monetary policy--and zero interest rates--have not been effective up to this point in

stimulating the Japanese economy. Low interest rates, slow broad money growth,

and falling commercial loans are consistent with either a liquidity trap or the credit

crunch explanation. But the Tankan survey results and some other facts tilt the

balance of evidence towards the credit crunch view. In particular, the banking sector

was hurt by the temporary emergence of the so-called "Japan premium" (extra

expense Japanese banks must pay for raising funds in overseas markets) and by the

downgrading of the investment ratings (by agencies such as Moody's) on debt issued

by Japanese financial institutions. More generally, the overall negative publicity

about the Japanese financial system and economy clearly contributed to a very

pessimistic atmosphere in Japan in the late 1990s.

To address the banking and credit crunch problems, public funds totaling 60 trillion

yen (12% of GDP) finally were set aside in 1998-1999 to recapitalize banks. A

number of institutions have used these funds (via the issuance of special equity

shares to the government) to increase capital-asset ratios significantly. In principle,

this should ease the credit squeeze and induce banks--particularly with further

injections of liquidity into the banking system--to increase lending. Long-delayed

capital injections and restructuring of the banking system should finally help push

Japan's economy into an expansion. The analysis here suggests that bank

recapitalization should ease the credit crunch, and, if the BOJ keeps interest rates

low, economic growth will soon follow.

Michael Hutchison

Professor, UC Santa Cruz, and Visiting Scholar, FRBSF

References

Cargill, T., M. Hutchison, and T. Ito. 1997. The Political Economy of Japanese Monetary

Policy. Cambridge, MA: MIT Press.

Cargill, T., M. Hutchison, and T. Ito. Forthcoming. Financial Policy and Central Banking in

Japan. Cambridge, MA: MIT Press (November 2000).

Krugman, Paul. 1998a. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap."

Brookings Papers on Economic Activity 2, pp. 137-205.

Krugman, Paul. 1998b. "Japan: Still Trapped?"

<http://web.mit.edu/krugman/www/japtrap2.html> (accessed June 6).

Spiegel, Mark. 2000. "Inflation Targeting for the Bank of Japan?" FRBSF Economic Letter

2000-11 (April 7).

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the

Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.

Editorial comments may be addressed to the editor or to the author. Mail comments to:

Research Department

Federal Reserve Bank of San Francisco

P.O. Box 7702

San Francisco, CA 94120

56

NOTES 3

57

Cumulative FINAL EXAM

Midterm Topics + Federal Reserve (Ch. 13)

Supply of Money (Ch. 14)

Tools of Monetary Policy (Ch. 15)

Conduct of Monetary Policy (Ch. 16)

Demand for Money (MD) (Ch. 19)

MD implications on IS-LM model

IS (Ch. 20)

Transition Mech. of M. Policy (Ch. 25)

Graphs to know

Market for Bonds (P x Q)

Market for Money (i x M)

Md Keynesians vs. Monetarists

Market for Reserves (fed funds rate x R)

IS-LM-FE ( i x Y)