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Because capital account plus current account must equal zero, any capital export by Japan would necessarily have as its counterpart an increased current account surplus - which means that it would help close the savings-investment gap. So plonking is exactly what the doctor ordered - and in any case, the incentive to plonk is already taken account of by the standard framework.

Slightly less amazing, but still a bit puzzling, is the common objection that pushing the real interest rate below zero would weaken the yen. Indeed it would - but that is true of any interest rate reduction.

If Japan currently had 5 percent interest rates, but its macroeconomic situation was otherwise the same, there would be almost universal approval for rate cuts by the Bank of Japan. What's so special about zero? Still, many people clearly are made uncomfortable by the idea of deliberately seeking inflation, and the Japanese government is trying other ways of getting the economy moving. Is the assessment that the economy needs a negative real interest rate still valid? I cannot see any way to deny the proposition that the Japanese economy, as currently constituted , would need a negative real interest rate to achieve full employment.

The most commonly cited policy instrument is bank reform. Although clear thinking is not exactly prevalent in this discussion, presumably the idea is that Japanese investment is depressed because undercapitalized banks are unable to provide firms with adequate credit. I have criticized this view in an earlier note, and discussed the role of financial intermediation at length in my Brookings Paper. Let me simply reiterate the main points. First, Japan has not suffered from anything like a bank run; and as long as undercapitalized banks have no trouble retaining depositors, economic logic suggests that they should if anything lend too much rather than too little.

Second, even anecdotal evidence of credit constraints dates, at the earliest, from late ; there is no evidence at all for the idea that the prolonged stagnation of the economy before then was due to inadequate intermediation. Third, while tightening of capital standards has led to some complaints about credit constraints over the past year, much of this probably represents banks acting more, not less, appropriately. That said, it is possible that recapitalizing the banks will reverse some of the recent credit squeeze - if only because the regulators will decide, once again, to look the other way.

But this would at best only return Japan to the very unsatisfactory status quo ante; it is highly unlikely that it would shift the investment schedule out sufficiently to resolve the liquidity trap. Which leaves us with fiscal policy - essentially, resolving the savings-investment gap by having government deficits absorb the excess savings. One question one might ask about the idea of resolving Japan's trap with deficit spending is, why would this be considered a preferred alternative to a negative real interest rate?

Suppose that the private sector is so into deferred gratification that at the margin it is willing to trade off one real yen of consumption now for slightly less than one real yen in the future. What's wrong with that?

AS/AD short and medium run equilibrium

Why force the public to consume more now and less later than it apparently wants to? Do we regard price stability as so important a goal that it trumps the usual principle that prices such as the real interest rate should be allowed to reach a level that matches supply and demand? But anyway, as a practical concern the main point about fiscal policy in Japan is that it is clearly nearing its limits.

Over the course of the past 7 years Japan has experienced a secular trend toward ever-growing fiscal deficits; yet this has not been enough to close the savings-investment gap. One need not claim that fiscal policy is completely ineffective: as Adam Posen has emphasized, fiscal expansion has pushed up Japanese growth when tried. But how much fiscal expansion can the government afford?

Between and Japan's consolidated budget went from a surplus of 2. When the Hashimoto government, alarmed by the long-run fiscal position, tried to narrow the deficit in the result was a recession; now fiscal stimulus is being tried once again.


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But projections already suggest that Japan may be heading for some awesome deficits - say 10 percent of GDP next fiscal year - with no end to the need for fiscal stimulus in sight. Given that Japan is already in far worse fiscal shape than, say, Brazil on every index I can think of - not just current deficit, but debt to GDP ratio and hidden liabilities arising from an aging population, the need for bank and corporate bailouts, etc.

Any economist who knows his theory but has also watched real-world policymaking knows that there are actually two quite different sorts of "conventional wisdom" in the world of economic affairs. On one side there are the standard, textbook economic models - like the IS-LM model - that shape informed policy analysis and discussion. On the other there are the "canons of orthodoxy and 'soundness'" the phrase is from Ragnar Nurkse's International Currency Experience that define what a responsible central banker is supposed to sound like.

Nurkse went on to point out that "It is characteristic of such canons that they tend to assume an independent existence of their own. Certainly nothing in the textbooks suggests, to take a non-random example, that price stability is as important a principle as most finance minsters and central bankers suppose it to be. Still, most of the time the standard textbook analysis and the orthodoxy of central bankers are at least reasonably in accord.

IS-LM Model

But what happens if a change in circumstances places bankers' orthodoxy and basic economic analysis in conflict? In the Classical case, the AS curve is vertical at the full employment level of output. Firms will supply the equilibrium level of output whatever the price level may be. Now, the fiscal expansion shifts the AD curve rightwards, thus leading to an increase in the demand for goods, but the firms cannot increase the output as there is no labour force which can be obtained. As firms try to hire more labour, they bid up wages and their costs of production and thus they charge higher prices for the output.

The increase in prices reduces the real money stock and leads to an increase in the interest rates and reduction in spending.

Technical Note on the ISLM and ASAD Models

The equation for the aggregate supply curve in general terms for the case of excess supply in the labor market, called the short-run aggregate supply curve, is. The real wage has a negative effect on firms' employment of labor and hence on aggregate supply. The price level relative to its expected level has a positive effect on aggregate supply because of firms' mistakes in production plans due to mis-predictions of prices.

The long-run aggregate supply curve refers not to a time frame in which the capital stock is free to be set optimally as would be the terminology in the micro-economic theory of the firm , but rather to a time frame in which wages are free to adjust in order to equilibrate the labor market and in which price anticipations are accurate. In this case the nominal wage rate is endogenous and so does not appear as an independent variable in the aggregate supply equation.

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The long-run aggregate supply equation is simply. In this long-run case, Z 2 also includes factors affecting the position of the labor supply curve such as population , since in labor market equilibrium the location of labor supply affects the labor market outcome. The following summarizes the exogenous events that could shift the aggregate supply or aggregate demand curve to the right. Exogenous events happening in the opposite direction would shift the relevant curve in the opposite direction.

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The following exogenous events would shift the aggregate demand curve to the right. As a result, the price level would go up. In addition if the time frame of analysis is the short run, so the aggregate supply curve is upward sloping rather than vertical, real output would go up; but in the long run with aggregate supply vertical at full employment, real output would remain unchanged. The following exogenous events would shift the short-run aggregate supply curve to the right. As a result, the price level would drop and real GDP would increase.

For example, a shock increase in the price of oil is felt by producers as an increase in the factors of production. This shifts the supply curve upward by raising expected inflation. This slows the adjustment of the AS curve back to its steady state. As the inflation slowly falls, so will the AS curve back to its steady state. The modern quantity theory states that the price level is directly affected by the quantity of money.

Milton Friedman was the recognized intellectual leader of an influential group of economists, called monetarists , who emphasize the role of money and monetary policy in affecting the behaviour of output and prices. The modern quantity theory also disagrees with the strict quantity theory in not believing that the supply curve is vertical in the short run.

Thus, Friedman and other monetarists made an important distinction between the short run and long run effects of changes in money. They said that in the long run money is more or less neutral : changes in the nominal money stock have no real effects and only change prices. But in the short run, they argue that monetary policy and changes in the money stock can have important real effects.


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