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International Creditors under the World Dollar Standard: Japan’s Liquidity Trap Redux

International Creditors under the World Dollar Standard: Japan’s Liquidity Trap Redux. Ronald I. McKinnon (Stanford) Rishi Goyal (IMF). Thesis: Conflicted Virtue. Creditor economies with: history of current account surpluses and build up of liquid foreign currency claims

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International Creditors under the World Dollar Standard: Japan’s Liquidity Trap Redux

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  1. International Creditors under the World Dollar Standard:Japan’s Liquidity Trap Redux Ronald I. McKinnon (Stanford) Rishi Goyal (IMF)

  2. 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

  3. 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

  4. 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

  5. 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

  6. Investment is weak at low interest rates

  7. 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)

  8. Model (2) • Goods market equilibrium: Y = C(Y–T, i–pe–ra)+I(i,pe)+G+NX(q,Y–T) • Real exchange rate and inflation: q = S P*/P pe = Dse + p*e – Dqe(Y – Yf) • Foreign asset accumulation: Ft+1 = (1+i*) Ft + NXt (Pt/St)

  9. 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

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