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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)